785 / How can community property law affect the federal income tax treatment of investment income?

In the states of Arizona, California, Nevada, New Mexico, and Washington, income from separate property is separate property of the spouse who owns the property. In the states of Idaho, Louisiana, and Texas, income from separate property is community property. (In Wisconsin, under the Marital Property Act, income from individual (separate) property is marital (community) property. For federal income tax purposes, the IRS has recognized that spouses’ rights under the Wisconsin Marital Property Act are community property rights.)² In May 1998, Alaska adopted a wholly consensual community property statute, which allows married couples to select which assets are community property and which assets are to be held in some other form of ownership. Both resident and non-resident married couples may classify property as community property by transferring it to a community property trust which has been established under the provisions of the statute.

In all community property states, the income from community property is, of course, community property. And in all states, spouses can have community property converted to separate property by partitioning or by making gifts or sales of their community interests in property. For federal income tax purposes, the distinctions between separate property and community property are important when the spouses file separate returns.

The rules in all community property states for determining whether property is separate or community are quite similar. In general, separate property is (1) property owned by a spouse before marriage and brought into the marriage as such, (2) property acquired by a spouse by gift, will or inheritance during marriage, and (3) property exchanged for separate property or bought with separate funds during marriage. Once property is identified as separate property, it remains separate property as long as it can be traced. All other property is community property (i.e., property owned one-half by each spouse). Earnings of the spouses while domiciled in a community property state are community property. Property acquired during marriage with community funds is presumed to be community property even if title to the property is taken in the name of one spouse only. The presumption can be rebutted only by clear and convincing evidence that the spouses intended the property to be the separate property of the spouse who has title.

The Tax Court held that a married couple’s marriage contract had the effect of stopping the application of Louisiana’s community property laws for federal income tax purposes, noting that, shortly before marrying, the couple “filed for registry” (in the parish where both of them resided) a marriage contract stating that “the intended husband and wife shall be separate in property.”³

In general, if property is bought partly with community funds and partly with separate funds, the property is partly community and partly separate in proportion to the source of the funds. If the property is bought with separate and community funds that have been so commingled that it is not known what part is separate and what part is community, the whole will probably be considered community, and consequently the property purchased will likewise be community. But see Q 788 for a different effect of commingling when spouses move to a noncommunity property state.

The IRS may disallow the benefits of any community property law to any taxpayer who acts as if he or she were solely entitled to certain income and failed to notify his or her spouse before the due date (including extensions) for filing the return for the taxable year in which the income was derived of the nature and amount of such income.⁴ In Service Center Advice, the Service stated that taxpayers domiciled in community property states have an undivided one-half interest in the entire community so that their filing status must be married filing jointly or, if married filing separately, their returns must each reflect one-half of the total community income and expenses. The Service must establish facts and evidence to demonstrate that IRC Section 66(b) applies (i.e., it may disregard community property laws where the spouse is not notified of community income).⁵

A California appeals court held that a spouse’s early retirement benefit must be characterized as community property where (1) the benefit is payable pursuant to a contract entered into during the marriage, and (2) the years of qualifying employment occurred before the parties’ separation.⁶

The Tax Court held that in a community property jurisdiction, the spouse of a distributee who did not receive a distribution from an IRA should not be treated as a distributee (under IRC Section 408(d)) despite whatever his or her community property interest in the IRA may have been under state law. Thus, under these circumstances, distributions are taxable to the distributee and the penalty tax (under IRC Section 72(t)) applies to the distributee spouse, only.⁷

The Tax Court also held that a taxpayer’s gross income from his continued employment—which he received in lieu of retirement benefits—did not include the amount of payments to which his former spouse was entitled under California community property law on the basis of the pension earned by the taxpayer. However, the appeals court reversed the Tax Court’s decision, holding that the fact that the taxpayer owed money to a creditor—in this case his former spouse—did not justify excluding any amount of his wages from income.⁸

For guidance on the classification for federal tax purposes of a qualified entity that is owned by two spouses as community property under the laws of a state, foreign country, or possession of the United States, see Revenue Ruling 2002-69.⁹

For more information, see IRS Publication 555, Federal Tax Information on Community Property.