If you live in a community property state, the law considers any assets and money earned by either marriage partner to be “community property.” This means that half of those assets and money belong to your spouse. Community property states also recognize “separate property,” which is any type of asset, money, or gift that was obtained before you got marriage, or after you separated from your spouse.
In the United States, there are nine community property states:
• New Mexico
It’s important to understand the implications of living in a community property state when you file taxes, when creditors pursue you for overdue bills, of if you decide to divorce. Let’s examine each scenario.
According to the Internal Revenue Service, if spouses in a community property state file separate returns, each partner will be taxed on half of the income for the community property – and it doesn’t matter which spouse has earned the income. Also, each partner will be taxed 100% of their separate property income.
If one spouse fails to pay taxes, and the IRS needs to take action to collect taxes, it can take the funds from community assets even if only one spouse owes money. While the law may vary among community property states, even if the assets are in the name of the other spouse, the IRS can pursue collection activities.
When couples file a joint tax return, they are jointly liable by federal law, so the issue of community property is not as important.
Since the goal is to limit your tax liability, work through the numbers to decide if filing separately or jointly will produce the greatest savings. TurboTax recommends considering the following to determine if filing separately might be more beneficial:
- Assets you owned before you married and income they generate
- Inheritances and personal gifts you received before or during the marriage
- Separate money used to buy or improve jointly owned property
- Medical and personal expenses paid with separate funds
- Individual IRA contributions and withdrawals
- Separate business income
- Community assets you have legally changed to separate assets
TurboTax also notes that in the states of California, Washington, and Nevada, same-sex registered domestic partners are subject to community property law. However, unless they’re married and the marriage is recognized by state law, they can’t jointly file a federal return. Also, in California, these individuals must complete a mock married-filing-jointly 1040 return for their state return.
The IRS is not the only organization that might come after a debtor’s spouse when an account is in arrears. Some couples try to use the separate property loophole to limit a debtor’s reach. However, depending on the community property law in that state, some or even all of shared property might be used to repay debts owed by one spouse.
In seven of the community property states (Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, and Wisconsin), when spouses are legally separated or divorced, the community property estate is terminated. However, merely living apart or even filing a petition for divorce is not considered an official dissolution.
In the remaining two community property states (California and Washington), a physical separation (with the intent to end the marriage) is sufficient to terminate the community property estate.
According to NOLO’s Divorce.net, a spouse is entitled to a portion of the retired spouse’s pension. By dividing the total number of years that the spouses were married by the total number of years that the working spouse contributed to the pension plan, the percentage owed the other spouse can be derived.
To help simplify this scenario, Divorce.net provides the following example: if the husband contributed to the pension plan for 20 years, and lived with his wife for 10 of those years, the community property share is 50% (10 divided by 20). So, his wife would receive half of the 50% (which is 25%).
The non-working spouse also has a role in determining when to receive part of the pension benefits. For example, if the husband could take early retirement at the age of 55, but elects to keep working, the ex-wife can decide that she wants her share sooner rather than later. As such, she can legally require him to pay her what she would have received had he retired at the age of 55. But, if she chooses this route, the ex-wife would not be entitled to any type of cost-of-living increases that might occur later.
These are just some of the components of a community property state – and why it matters if you live in one. However, there are many other elements that should also be understood. If you live in a community property state or you’re thinking of moving to one, consult the individual laws of that particular state for more information on how your taxes and debts – as well as a possible divorce – would affect you.