In nine states, community property rules alter the way marital income is treated for tax purposes.
Table of Contents
Community property states treat marital income differently than other states (which are sometimes called common law states). As a result, the tax law has special rules for community income. The IRS Restructuring and Revision Act of 1998 revised the treatment of spousal liability, and includes rules for community property states.
Special rules apply to spousal property and income in the community property states:
- New Mexico
Joint Tax Returns
Some or all income earned by one spouse may be community incomein these states. As a general rule, that means the tax rules will treat this income as if each spouse earned half of it. If you and your spouse file separate returns, each of you has to report half of the community income. In addition, you would report half of the income produced by any property that’s treated as community property (for example, savings bonds that are purchased with community income). You would also report the entire amount of any income you have that’s treated as your separate income under the laws of your state.
If you live in a community property state you’ll be subject to somewhat different rules for spousal liability (and relief from spousal liability).
You can learn more about tax reporting in community property states by obtaining IRS Publication 555.
If you file jointly with your spouse, you’ll generally obtain relief from spousal liability under the same rules that apply to taxpayers in common law states (states that do not have community property laws). The law provides:
“Any determination under this section shall be made without regard to community property laws.”
This means that any item that would otherwise be attributable to your spouse won’t be split between you because it happens to relate to community income. However, as we understand this provision, it doesn’t prevent you from being taxable on your half of the income produced by community property.
Example: Your spouse fails to report some of the income from your spouse’s business. In addition, your return doesn’t include the income from mutual fund shares your spouse bought with community income. Under the rules providing relief from spousal liability, you don’t have to treat half of the business income as your own. But half of the income from the mutual fund is yours, because the income was produced by property you own jointly with your spouse.
Apart from splitting income that’s produced by property you own jointly with your spouse by virtue of the community property laws, you should apply the rules described in other pages of this guide to relief from spousal liability as if you lived in a common law state, not a community property state.
Liability on Separate Returns
Normally you aren’t liable for tax relating to your spouse’s income if you file separate returns (assuming there’s no fraudulent transfer of assets from your spouse to you). But if you live in a community property state, you’re required to report half of the community income earned by your spouse on your return. If the IRS determines that the community income earned by your spouse was greater than you thought it was, you can be liable for tax on your share of that income even though you filed a separate return.
The tax law provides relief from liability for tax on community income on separate returns under rules similar to the Innocent Spouse Rule. The tax law also provides that the IRS can impose tax solely on one spouse if that spouse treats community income as his or her own and fails to notify the other spouse of the amount and nature of the income before the due date of the return for that year. The 1998 tax law added a new provision under which the IRS can grant relief where it would be inequitable to collect the tax even though the taxpayer doesn’t qualify for relief under the general rule.
We don’t expect the IRS to use this rule in every instance where the taxpayer feels that the law is unfair. Yet there are likely to be situations where the facts are particularly appealing and the IRS actually wants to provide relief. Before the 1998 tax law, the IRS had little choice but to enforce the law as it was written. Now the IRS can exercise discretion in appropriate cases.