Equally Yours: Tax Considerations in Community Property States

Understanding the intricacies of community property laws is essential for married couples residing in the nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. These laws dictate that most assets and income acquired during the marriage are owned equally by both spouses, which significantly impacts tax considerations.

1. Income Allocation:

Example: Consider a couple where Spouse A earns $90,000 annually, and Spouse B earns $30,000. In a community property state, if they file separately, each spouse must report half of the combined income, i.e., $60,000, on their individual tax returns, regardless of who earned it.

2. Separate vs. Community Property:

Example: Spouse A owned a rental property before marriage, generating $10,000 in annual rental income. This property is considered separate property, and the income remains separate. However, if the rental income is deposited into a joint account and used for mutual expenses, it may be deemed commingled, potentially converting it into community property.

3. Deductions and Credits:

Example: If Spouse A has significant medical expenses that exceed 7.5% of their adjusted gross income (AGI), filing separately might allow for a larger deduction. However, in community property states, since income is split equally, the AGI used to calculate the deduction threshold would be half of the combined income, potentially affecting the deductible amount.

4. Estate and Gift Taxes:

Example: Upon the death of Spouse A, who jointly owned a home with Spouse B as community property, the property's basis is "stepped up" to its fair market value at the date of death. If the home's original purchase price was $200,000 and its market value at Spouse A's death is $350,000, the basis for Spouse B becomes $350,000. This adjustment can significantly reduce capital gains taxes if Spouse B decides to sell the property later.

These examples illustrate the complexities of community property laws and their impact on taxation. Given the nuances involved, it's advisable for couples in community property states to consult with a tax professional to ensure compliance and optimize their tax situations.