Keeping finances separate in a community property state

This year has been the year many California preparers, including myself, have become far more familiar with the legal intricacies of community property law than we ever imagined we would be.

This was the first tax season in which the IRS has required same-sex married couples and Registered Domestic Partners to use community property law if they live in a community property state that recognizes their relationship (currently, California, Nevada, and Washington are the 3 this applies to). Community property law is nothing new–it’s been around for centuries–but the tax implications of it have not been greatly explored for a simple reason: Couples subject to community property rules have historically been allowed to (and nearly always do) file a joint tax return with all income from both members of the “community” reporting their income on one tax return.

Because same-sex couples aren’t legally allowed to file joint Federal tax returns, they must sort out who gets what under the sometimes nearly incomprehensible rules of community property so they know what to report on each person’s individual return. The basic idea is simple: In a marriage or other relationship in which community property applies, all income earned while the union exists belongs equally to both members of the relationship. But like many basic principles in taxes and the law in general, what sounds simple at first becomes very complex in the real world.

[One of my favorite examples of a simple thing becoming highly complex is how to treat pension income. Legally, when one partner receives pension income, a portion of the income is “community income” and a portion is “separate income.” The way you determine which is which is by looking at all the money that ever went into that pension and determining how much of that money was earned prior to the community property union, and how much was earned during the union. You’ve kept all your pay-stubs for your entire working life, haven’t you?! (If you have, I want you as a client! So far all my clients are real, normal people who don’t have documentation for every transaction in their entire life…)]

So while most couples who’ve been together a long time have their own ideas of what’s mine, yours, and ours, when it comes time to do taxes, everything must be categorized as either mine or yours and it must be done according to specific rules. So you might think it makes sense for the higher earning spouse to deduct all the mortgage interest that came from a shared account, but the reality can be much more complex. For starters, the “higher earner” usually isn’t the higher earner after half of the earnings are allocated to (and reported on the tax return of) the other partner. More to the point is the fact expenses that are paid from “community” funds are almost always deemed to be paid one half by each partner.

This rule can be problematic for certain expenses. For instance, medical expenses are best paid from “separate funds” for two reasons–one reason is related to tax calculations, but the other reason is a simple matter of the IRS may disallow the deduction for the partner who didn’t actually incur the medical expenses because the other partner is not legally “family”.  Many expenses could potentially become partially non-deductible if paid from community funds, or could offer better tax benefit if paid from separate funds.

Most student expenses can be paid from community or separate funds (because school expenses paid by somebody other than the student are generally deemed to be paid by the student anyway), but student loan interest payments should probably be paid with separate funds. Investment and tax preparation expenses should generally be paid from separate funds for maximum tax benefit.  Child care expenses should also be paid from separate funds to avoid having half the credit potentially disallowed. There are far too many areas to list them all, but that’s just some of the more common expenses that are best paid from “separate” funds.

Now that brings us to the question of what are “separate” funds, or “separate” assets, or “separate” property? Legally separate property includes any assets or property a partner brings into a community property relationship, as well as any property acquired during the relationship by gift or inheritance. As long as such property is not significantly intermingled with “community” property–such as earnings from a job–the property will remain separate. So, for instance, both partners may bring their own savings accounts into a relationship, and both partners have their paychecks deposited into those savings accounts. The accounts start out as separate property, but since they are intermingled with community income, they will become community assets over time. (How much time? There’s some real grey area here, but the key is how large the paychecks are relative to the account balance at the beginning of the relationship.)

So let’s say a couple has been together a long time and all of their assets are so intermingled that everything is community property at this point. If this couple wants to establish “separate” funds for the purposes above (and others), how do they do that? Unfortunately, it’s not as simple as just putting only one partner’s name on a bank account. If the funds in the bank account are community income (like most earnings), then the account is community property. To have separate property, remember, the property must have been brought into the relationship, or acquired by one partner through gift or inheritance. Establishing a separate account after the relationship requires you to fund the account with either income from separate property (e.g. funds from Social Security or a pension earned before the relationship, or income from a rental property owned ahead of time) or property received by gift or inheritance.

If there weren’t significant assets brought into the relationship, that seems to leave you waiting for a rich uncle to give you a fat birthday check or an inheritance.  However, there is one nice trick I learned from a lawyer (who regularly works with community property issues) that makes this much easier.  One partner can simply give a gift to the other partner. Write a check for $10,000 from one partner to the other out of a community account. $5,000 is deemed to be a gift (the other $5,000 belonged to the recipient already under community property law) and therefore the separate property of the recipient. You can do this with up to $26,000 each year (half the total, $13,000, is deemed to be a gift) without having to file a gift tax return.

Using this simple method, as well as keeping other separate items such as pension income in separate accounts, will allow partners to truly determine who paid what for tax purposes. There are many advantages to this, depending on your tax situation. You should probably consult with a tax professional about your specific situation, but there are some general rules of thumb.

  • Any personal deductions that clearly relate to one partner or the other (e.g. medical expenses, education expenses, etc.) should be paid by that partner from separate funds.
  • Any deductible expenses related to a child should be paid from separate funds by the partner who claims the deduction for that child.
  • Any deductible expenses related to property that is titled in only one partner’s name (e.g. Real Estate taxes and mortgage interest on the home the couple lives in, but only one name is on the title) should be paid with separate funds by the person on the title.

(A community property lawyer might  take issue with the last one since there’s a good legal argument that even the person who is not on the title should still legally be able to claim the deduction…but just because you think you can win an argument in court doesn’t mean you shouldn’t avoid the argument in the first place if possible. My advice is use separate funds and have the partner on the title take the entire deduction in order to avoid a dispute with the IRS.)

Look for a follow up post at some point enumerating more examples of what expenses are best paid from separate funds along with a little more explanation. For now, hopefully that gives you some basic pointers on when to use separate funds to pay for deductible expenses, and how to establish what is “separate” if you’re in a community property state.

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