As the first part of this article discussed, couples who live in community-property states enjoy opportunities that those in other states do not. There are a number of ways in which couples that own community property can save money on income taxes. However, using community-property laws to their best advantage presents some challenges.
Making money from separate returns
Another advantage of living in a community-property state is that it sometimes makes it advantageous to file a separate tax return. For most couples, filing separately results in paying more income tax, because the spouse with more income enters higher tax brackets than the couple would if they filed jointly. However, because community property treats most income and expenses during marriage as having been earned 50% by each spouse, the separate returns usually look extremely similar, and there isn't usually a tax penalty for filing separately.
As a result, under certain circumstances, you may pay less tax by filing separately than by filing a joint return. This usually occurs when one spouse has extraordinary expenses that were paid from separate property, such as medical expenses or miscellaneous deductible expenses. The amount you can deduct from your tax return for these expenses depends on your adjusted gross income. In simple terms, filing separately usually reduces the adjusted gross income on your return by half, potentially allowing you to deduct more of your extraordinary expenses. The calculations are complicated enough that you'll probably have to run your returns using both methods to determine which way saves you the most money.
Planning challenges
Community property can present some obstacles to a couple's financial planning. For instance, if you want to preserve separate property, you have to be particularly careful to account for it separately. If you allow separate property and community property to mix in the same accounts, you'll probably end up having to treat it all as community property. Furthermore, in some states, the income generated by separate property during marriage is treated as community property. So if you own dividend-paying stocks such as Procter & Gamble (NYSE:PG), Altria Group (NYSE:MO), or Heinz (NYSE:HNZ), you must be careful to avoid creating a problem by commingling community-property dividends with separate-property stock holdings.
In addition, community-property rules governing debts of married couples sometimes require that both spouses act in concert to make major financial decisions. For instance, in some states, one spouse cannot take out a mortgage or home-equity loan on real estate without the other spouse's consent. However, for other types of loans, including credit-card debt and other unsecured loans, either spouse can unilaterally incur debt. These loans often become community debts, and banks can collect against community property assets in the event of default, even if the other spouse never knew about the loan. As a side note, these issues aren't isolated to community-property states; many other states also impose joint liability for the debts of one spouse.
Finally, matters become even more complicated when people move in and out of community-property states. Many of the states that don't offer community-property laws to their residents nevertheless respect the existence of community property among people who formerly lived in other states with such laws. In this case, you may find your goals reversed; you may need to make an effort to keep the community-property assets you obtained when you lived in another state separate from the money you earn in your new home.
Finding good solutions
You can resolve the challenges of community property in several ways. Perhaps the simplest way to deal with the issues of keeping separate and community property distinct is to avoid them entirely by treating all of your assets as community property. Unless there's a large disparity in wealth between the two spouses entering the marriage, treating everything as community property rarely makes a significant difference financially but makes managing your money much easier. Some states allow spouses to use a document called a community-property agreement to declare all of their assets as community property.
If, however, it's important to maintain the separate status of property brought into the marriage or subsequently received by gift or inheritance, then you'll have to be more careful. Keeping segregated accounts for your separate property can help you avoid mixing separate and community property. Some couples create special trusts to hold their separate property, allowing them to dispose of the trust assets in any way they wish. Keep in mind that no matter what method you use to keep your separate property, you always have to be careful to keep community-property assets away from it.
In many cases, combining the use of segregated accounts or trusts for separate property with the creation of a prenuptial agreement is the best way to make sure that your wishes for your separate property are met. While community and separate property designations control the disposition of marital assets at death, courts in most states retain the right to make unequal distributions of both community and separate property to spouses upon divorce. A valid prenuptial agreement can avoid the uncertainty involved with such a court-ordered division of property.
When you first encounter community-property laws, they may seem confusing and unnecessary. For many couples, they merely formalize the financial arrangements that two spouses intend to use anyway. However, the benefits of community property can result in large income-tax savings. Therefore, it's worth your time to understand exactly how community property works in your state and how you can use it to achieve the best result for your family.
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Fool contributor Dan Caplinger has tried living both with and without community-property laws and has settled on going without, at least for now. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't leave you out in the cold.
