Community Property States: How Spousal Tax Relief Works When Half Your Spouse's Income Is "Yours"

In most states, filing a separate return separates you from your spouse's income. In community property states, it may not. State law can make half of your spouse's earnings your income, even if you never saw a dollar of it. That can leave a separated spouse owing tax on money that went into someone else's pocket.

Federal tax law has specific rules for this. This guide explains them.

Which states

The Form 8857 instructions, the Form 8379 instructions and IRS Publication 504 list the same nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Publication 504 explains the basic rule: if your domicile is in a community property state during any part of the tax year, you may have community income, and your state law determines whether income is separate or community. Generally, community property laws provide that each spouse is entitled to one-half of the total community income.

Problem one: you filed separately but are taxed on your spouse's income

Internal Revenue Code section 66 provides three tools for this.

Section 66(a): spouses who lived apart all year

Section 66(a) says that if two people are married at any time during a calendar year, live apart at all times during that year, do not file a joint return with each other, have earned income that is community income, and transfer none of that earned income between themselves before year-end, then community income is treated under the rules of section 879(a).

Publication 504 explains what that means in practice. Earned income that is not trade or business or partnership income is treated as the income of the spouse who performed the services. Trade or business income goes to the spouse carrying on the business. Partnership income goes to the spouse who is the partner. Income from separate property goes to the spouse who owns it. Social Security benefits go to the spouse who receives them. Other community income, such as dividends, interest and rents, follows state community property law. Publication 504 says transfers satisfying child support obligations or transfers of very small amounts are not taken into account for the no-transfer condition.

If you lived apart all year and kept your earnings separate, this rule is automatic. You report your own earnings, not half of your spouse's.

Section 66(b): the spouse who hid income

Section 66(b) lets the IRS disallow the benefits of community property law to a spouse who acted as if solely entitled to income and failed to notify the other spouse of its nature and amount before the return due date, including extensions. Publication 504 describes this as community income not treated as community income by one spouse: the spouse who kept it to himself or herself is responsible for reporting all of it.

Section 66(c): relief for the unaware spouse

The first sentence of section 66(c) provides relief when:

1. You did not file a joint return for the year.
2. You did not include in gross income an item of community income that, under section 879(a), would be treated as your spouse's income.
3. You establish that you did not know of, and had no reason to know of, that item.
4. Taking into account all facts and circumstances, it is inequitable to include the item in your gross income.

If you qualify, the item is included in your spouse's gross income and not yours. Publication 504 lists the kinds of items this covers: your spouse's wages, sole proprietorship income, distributive share of partnership income, income from your spouse's separate property, and any other income that belongs to your spouse under community property law.

The second sentence of section 66(c) adds equitable relief: the IRS may relieve you of liability for unpaid tax or a deficiency attributable to an item for which relief is not available under the first sentence, if holding you liable would be inequitable.

Deadlines are different

The Form 8857 instructions say that for relief under the first sentence of section 66(c), you must file Form 8857 no later than six months before the period of limitations on assessment against your spouse expires for that year, including extensions. If the IRS begins an examination of your return during that six-month period, the latest time is 30 days after the IRS's initial contact letter to you. Equitable relief under section 66(c) follows the general equitable relief timing rules.

The instructions also note that Tax Court review is not available for relief from liability for tax attributable to an item of community income under that first sentence. Revenue Procedure 2013-34 governs equitable relief under section 66(c), with the same factors used for section 6015(f), except that the threshold conditions requiring a joint return and unavailability of 6015(b) and (c) relief do not apply. See the guide to the section 6015(f) factors.

Problem two: you filed jointly in a community property state

If you filed a joint return, section 6015 is your relief, the same as in any other state. And section 6015(a) says any determination under section 6015 is made without regard to community property laws.

Treasury Regulation 1.6015-1(f) confirms that in deciding whether relief is available, items are generally allocated without regard to community property law, and an erroneous item is attributed to the individual whose activities gave rise to it. The regulation's example: a husband's unreported interest from his individual bank account is allocated to him, and a wife's disallowed business deductions are allocated to her, even though state law treats half of each as belonging to the other.

Treasury Regulation 1.6015-3(c)(2)(iv) adds a protection for actual knowledge analysis: in a community property state, you are not considered to have an ownership interest in an item based solely on community property law. You must have been named on the ownership documents or otherwise asserted dominion and control. See the guide to separation of liability.

Revenue Procedure 2013-34 adds that, for equitable relief, an item attributable to you solely because of community property law is treated as attributable to your spouse.

Problem three: your joint refund was offset

If your joint refund was applied to your spouse's separate debt, Form 8379 is the tool, but the math is different in community property states. The Form 8379 instructions say that for non-federal debts, such as child support, student loans, state unemployment debts or state income tax, 50 percent of a joint overpayment, excluding the earned income credit, is applied to the debt. Federal tax offsets depend on state law, and the earned income credit is allocated by each spouse's earned income. The instructions point to Revenue Rulings 2004-71 through 2004-74 for state-specific rules.

Publication 504 also says that if the injured spouse's permanent home is in a community property state, the injured spouse needs to meet only the condition of not being legally obligated on the debt. See the guide to Form 8379.

Separated but not apart all year

Section 66(a) requires living apart at all times during the calendar year. Publication 504 notes that separated spouses who do not meet all the conditions must treat income according to state law, and that in some states income earned after separation but before a divorce decree continues to be community income, while in others it is separate. Check your state's rule before you file. The guide to filing separately after separation covers the filing choice.

Putting it together: which tool for which problem

Community property cases often involve more than one tool at once, so here is a summary.

1. You filed separately, lived apart all year, and kept your earnings separate. Section 66(a) applies automatically. Report your own earned income.
2. You filed separately, and your spouse hid income from you. Section 66(b) may shift the income to your spouse, and section 66(c) may relieve you if you did not know and had no reason to know of it. File Form 8857 within the special deadline.
3. You filed separately and owe tax on community income you never received, but you did know about it. Equitable relief under the second sentence of section 66(c) is the remaining option, decided under the Revenue Procedure 2013-34 factors.
4. You filed jointly. Section 6015 applies, and community property law is disregarded in deciding relief.
5. Your joint refund was offset for your spouse's separate debt. File Form 8379, using the community property allocation rules.

Get the facts down first: where you were domiciled, when you separated, whether you lived apart the entire calendar year, and whether any earned income passed between you. Those four facts decide which rules apply.