Married Separate and Community Property
We've discussed the marriage penalty and using the Married Separate filing status as a potential strategy to overcome this penalty in other articles. Here we take a look at the "nuts and bolts" of using the Married Separate filing status, especially when dealing with community property states. (Please review the related articles for background information.)
In separate property states, the computations for the Married Separate filing are fairly simple -- you only report your own income and deductions on your separate return. If you have joint assets with your spouse, special consideration must be given to how those assets are split... but, generally, they are simply split right down the middle.
Separate... but Equal
However, in community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are all community property states), all earnings of either spouse, while they are married, generally are considered "joint," even if deposited into separate accounts. Assets purchased with joint funds may also be considered community assets. Therefore, in these states, it is much more difficult to identify separate property.
As I mentioned above, if you file a Married Separate income tax return in most states, you would report only your own income, deductions, exemptions, and credits on your separate tax return. But, if you live in a community property state, this means you and your spouse must each report half of your combined community income and deductions, in addition to your separate income and deductions. The way you figure these amounts is affected by the community property rules of your state. In effect, federal income tax law defers to state law property rules for tax reporting purposes.
Still not clear? Then let's take a look at this example:
Example: Philip and Mary are married and live in California. Philip's wages are $100,000 per year. Mary's wages are $30,000 per year. You would think that, if they elect to file a Married Separate tax return, they would each report their respective incomes on their own returns. But, since California is a community property state, they are actually required to combine both incomes (for a total of $130,000), and each report half of the total on their respective separate returns. So, in this case, using the Married Separate filing status, Philip and Mary would each report $65,000 in wages on their separate tax returns.
Before you prepare a tax return using the Married Separate filing status, you must first determine whether your income is community income or separate income, as determined under the laws of the state where you live. This classification is important because, if you file a separate return, only half the community income is reported on your return, but all of your separate income must be included on the return.
Separate Property Shell Game
Generally, community income is all income from community property (also determined under state law), as well as salaries, wages, and other pay for the services of either or both spouses during their marriage. But, income from a spouse's separate property (as determined under applicable state law) is the separate income of that spouse. For those of you who live in Idaho, Louisiana, Texas, and Wisconsin, you should be aware that income from most separate property is treated as community income in your state.
Whether income from real property is community income or separate income depends on the laws of the state where the property is located. If you and your spouse bought property during your marriage with both community funds and separate funds, income from the property would be partly community income and partly separate income.
Gains and losses from property are characterized as separate or community depending on whether the property producing the gain or loss is separate property or community property. Because of rules such as this, a casualty loss to your community property home would be deductible half by each spouse.
The way you split other deductions generally depends on whether the expenses relate to community income or separate income. Deductions for expenses incurred to earn or produce community business or investment income would be divided equally between you and your spouse. Deductions for expenses relating to separate business or investment income would be deductible by the spouse who is liable for the taxes on the income. Itemized deductions, such as charitable contributions or medical expenses, are generally considered paid from community funds and deductible half by each spouse, unless it can be shown that they were actually paid from separate funds, in which case they would be deductible by the spouse who paid them.
Identifying your community income and separate income and deductions according to the laws of your state is a very complicated task. This is why untrained people who try to use the Married Separate filing status sometimes find themselves on the wrong side of the tax laws and regulations. Therefore, before you try to file that return using the Married Separate status, your minimum required reading should be IRS Publication 504 and Publication 555. The time you spend now may well save you a bunch of hassles with Uncle Sammy down the line.