Community Property and The Federal Tax Implications

The IRS when assessing and collecting tax debt from a taxpayer follows the federal laws and regulations governing this but, when it comes to community property states and tax debt arising from community property, the IRS generally defers to the states’ community property laws as shown under Treasury Regulation (“Treas. Reg.”) § 1.66-1(b)(1). For taxpayers living in a community property state it is absolutely necessary to know what can be considered community property and what the tax implications are for the community property, especially after a legal separation or divorce.

First, here are the states that operate under community property law:

• Arizona
• California
• Idaho
• Louisiana
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin
• Alaska (this is an opt-in state that allows both parties to choose whether to make their property community property)

For the purposes of this discussion we will be analyzing the tax implications for community property in California.

WHAT IS COMMUNITY PROPERTY?

Community property under Internal Revenue Code § 66 is generally defined as any money earned, real or personal property obtained, or debts incurred while married.

• real and personal property are things such as a home, vehicles, furniture, luxury items, etc.

DOES ANYTHING STAY SEPARATE?

There are some things that do remain separate property when you are married.

• All property owned by a spouse prior to marriage
• Any property obtained by a spouse after legal separation or divorce
• If a spouse inherits or receives property as a gift from a third party while married, so long as that property is kept separate from the community property
• All debts incurred before marriage would remain separate from the community property

Separate property can become community property under certain circumstances i.e. comingling and the transmutation of property.

Example:

While married, you inherit a piece of land and $20,000. You then add your spouse’s name to the piece of land and the transmutation of the property is put in writing and signed. However, the $20,000 is kept in a separate bank account and never used for community property purposes. Because of the transmutation, the piece of land becomes community property but, the $20,000 kept in a separate bank account would remain separate property.

TAX IMPLICATIONS FOR COMMUNITY PROPERTY

Now that you have a better understanding of what can be classified as community property and separate property, let’s take a look at what the tax implications are for the community property.

As stated above, any debts incurred due to earned income or property while married become community property. This means that you and your spouse will both be 100% liable for those tax debts that were brought about because of the community property, even after you have legally separated or divorced.

Below are some key points regarding California’s community property laws:

1. California does not recognize common law marriage, unless the marriage was legally established elsewhere.
2. California does recognize some form of domestic partnership as an alternative to marriage, which in turn creates community property rights and obligations.
3. Post marital income from separate property is deemed separate property unless it is derived from community property time, effort, and skills. If this is the case, a portion of the separate property must be allocated to the community property based on the time, effort, or skills of the community property.
4. Appreciation in the value of separate property stays separate property if it occurs naturally but, if the appreciation is due to the spouse’s labor efforts or community property funds, it creates a community property interest in the separate property.
5. California does recognize pre and post marital property characterization agreements such as a prenuptial agreement.
6. When satisfying a pre-marital or post-marital tax obligation, 100% of all community property and all separate property of the liable spouse is able to be included in the collection efforts.

Though this may seem daunting, there are ways to be relieved of the tax debt arising from community property.

RELIEF FROM FEDERAL INCOME TAX RESULTING FROM COMMUNITY PROPERTY

When dealing with a tax liability resulting from community property, things can become even more convoluted than dealing with an ordinary tax liability. Under Treas. Reg. § 1.66-4 there are certain criteria for requesting relief. So, included with each relief option will be a detailed explanation or example.

1. If you did not file a joint tax return for the year in which the liability was assessed, you can request relief from the tax liability. This may seem like common sense but, there is a reason why this is important to mention.
   • In a community property state, when filing a married filing separate return, you will be reporting not only your separate income and deductions but one-half of community property income and deductions.
   • This means that even though you file a separate return, some of the community property income you are claiming may not have had enough taxes withheld from it and would cause you to have a tax liability when you file.

1. If you did not know, or have reason to know, of the item of community property, you can request relief from the tax liability assessed.
   • In a community property state, if your spouse were to obtain income or property that would be characterized as community property but, they did not make you privy to this information, you should not be held liability for the tax associated.
     • Furthermore, under Treas. Reg. § 1.66-3 if your spouse did in fact fail to notify you of the item of community property and acted as if they were solely entitled to the item of community property, they can be denied the federal income tax benefits derived from the community property.
   • In turn, if your spouse did not make you aware of the item of community property but, they were using it to pay for items that were considered community property, such as car payments of a jointly owned vehicle or mortgage payments for a property you lived in or was jointly owned, you would more than likely be deemed to have knowledge of the community property item.
2. If you did not include on your separately filed return an item of community property that would have been includible as such but, can be shown to be income gained solely from the efforts of your spouse, you can request relief from the tax liability associated with that income.
3. If you can prove it would be inequitable to include the item of community property in your gross income, you can request relief from the tax liability associated with the item of community property.
   • The biggest factor here is whether or not you directly or indirectly benefited from the item of community property. Benefits can include normal support, the transfer of property, or rights to property.
     • Benefits can also be seen as something you may receive years after the tax return is filed, such as proceeds from a life insurance policy if the money used to purchase the policy was from community income attributed to your spouse.

Relief from federal income tax liability resulting from community property is not available if you or your spouse transferred property to one another as part of a fraudulent scheme. This also encompasses if your spouse only transferred property to you as part of a fraudulent scheme.

If you have entered into a closing agreement or offer in compromise that includes the liabilities resulting from community property, you are unable to request this type of relief.

TIMING FOR SUBMITTING REQUEST FOR RELIEF

To request this type of relief you must wait until you have received a notice regarding an audit or outstanding tax liability. The latest date to request this type of relief is six months before the period of limitations on assessment.

If you are pursuing equitable relief for a tax debt arising from community property, you may submit the request for relief with your federal tax return or after the federal tax return has been filed.

OTHER TYPES OF RELIEF THAT MAY BE APPLICABLE

• Innocent Spouse Relief
• Relief by Separation of Liability
• Equitable Relief
• Signature Under Duress