Understanding Community Property Laws: Essential Insights for Arthur J. Gallagher Employees Approaching Retirement

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What Is Community Property?

As an employee of Arthur J. Gallagher, you may be interested to know more about community property. Community property laws establish a set pattern of property ownership for married couples. To date, community property laws are effective in 10 states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin have mandatory systems while Alaska has an optional system. Although the laws vary among these states, some general characteristics are shared by all.

Broadly speaking, in states that follow community property laws, property and income earned by spouses during their marriage while residing in a community property state are considered to have been equally acquired or earned by both, regardless of who contributed or earned it. As a result, each spouse is deemed to possess a 50% ownership interest in all such property or income.

In contrast, separate property states (or common law states) attribute all property and income to the person who acquired or earned it regardless of marital status. There are five exceptions to the above general rule that we'd like to ensure our Arthur J. Gallagher clients know:

•  Property acquired or income earned prior to the marriage remains separate property
•  Property received by one spouse as a gift, devise, or inheritance does not become community property
•  Property acquired as separate property or income earned while domiciled in a separate property state remains separate
•  Property (or the portion of the property) bought with separate funds or exchanged for a separate property during the marriage does not become community property
•  Property converted from community property through a valid agreement executed by both spouses becomes separate property

The following is an example of how community property states work as opposed to separate property states:

Example(s):  In a community property state — Carol and Richard have been married for two years and live in a community property state. With their combined income tax refund of $40,000, they purchase a motor home so they can explore America's national parks. Richard's refund is $25,000 and Carol's is $15,000. Because they live in a community property state, each spouse owns a one-half interest in the motor home regardless of who receives the greater portion of the refund. Therefore, Carol and Richard each have a 50 percent interest in the motor home.

Example(s):  In a separate property state — Cindy and Glenn have been married for two years and live in a separate property state.  With their combined income tax refund of $40,000, they purchase a motor home so they can explore America's national parks. Glenn's refund is $25,000 and Cindy's is $15,000. Because they live in a separate property state, each spouse owns an interest in the motor home proportionate to the funds contributed to purchase it. Therefore, Glenn has a 63 percent interest (approximately) while Cindy has a 37 percent interest (approximately).

Tip:  Personal property you acquire and income you earn generally retains its status (community or separate) during your lifetime regardless of where you move. In other words, if you and your spouse acquire property and earn income in a community property state, and then move to a separate property state, the property and income you already acquired retains its community property status.

Caution:  It's important that Arthur J. Gallagher employees note, this is a very broad discussion of community property rights and tax consequences. Because the laws vary a great deal from state to state, Arthur J. Gallagher employees should consult an attorney experienced in property law for advice about the laws in their particular state.

Do Community Property Laws Apply to You or Your Spouse?

To date, community property laws are effective in 10 states: Alaska (which has an optional system), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Whether you have community property and income depends on whether you and/or your spouse are, or have been, domiciled in one of these states during your marriage. Which is your state of domicile? The simple answer is the state in which your home is located. However, for Arthur J. Gallagher employees who have more than one home, the answer may not be so simple.

Legally, your domicile is a permanent home that you intend to use for an indefinite or unlimited period, and to which, when absent, you intend to return. You have only one domicile, even if you have more than one home. The amount of time spent in one place does not always explain the difference between domicile and home. A temporary home or residence may continue for months or even years, while a domicile may be established the first moment you occupy a property. It is your intention, as indicated by your actions that determine domicile. You must be able to show with facts that you intend a given state to be your permanent home. Factors to consider include:

•  Where you pay state income tax
•  Where you vote
•  Location of property you own
•  Your citizenship
•  Length of residence
•  Business and social ties to the community

Is It Separate or Community Property?

It is important for Arthur J. Gallagher employees to understand and correctly characterize property owned and income earned by a married couple as separate or community because of the tax consequences that result. The general rules follow.

Property Acquired or Income Earned During the Marriage

The general rule is that ownership of property acquired or income earned by a married couple during the marriage while domiciled in a community property state is considered shared equally between the husband and wife. Special rules apply if a couple lives apart or is in the process of divorce. Upon divorce, the community property may or may not be divided 50/50, depending on state law. Upon the death of one spouse, community property is generally divided, with 50 percent going to the surviving spouse and 50 percent going to the deceased spouse's estate.

Property acquired during a marriage may be classified as separate property if either spouse can show clear and convincing evidence that the property was obtained with separately owned funds. The status of the property can be proven with purchase records, receipts, title papers, records of bank account deposits and withdrawals, or any records that establish how the property was initially titled and held, which spouse provided the funds, or that the funds for the purchase came from separate assets.

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Property Acquired or Income Earned Prior to Marriage

Any property that either spouse acquired or income earned by either spouse prior to the marriage remains his or her own separate property.

Property Received By Gift, Devise, or Inheritance

If either spouse receives a gift, devise, or inheritance, it remains the separate property of the spouse who receives it, even if the property is acquired during the marriage.

Commingled Property or Property That Cannot Be Identified

If separate property and community property are mixed, or it is otherwise not possible to determine whether the property is separately or community-owned, the property is assumed to be community property.

Property Converted By Agreement

In most community property states, a husband and wife can agree to convert separate property to community property or vice versa. The agreement must be valid under state law. The separate property retains its classification as separate property unless there is clear and convincing evidence to show that it was converted to community property.

Earnings from Separate Property

In some community property states, earnings from separate property (e.g., rents, dividends, or royalties) are considered separate property. However, in other community property states, income from most separate properties is community property. Capital gain is often treated differently than interest or other ordinary income. Arthur J. Gallagher employees should see an attorney about their state's laws regarding this.

Proceeds from Disposition of Separate Property

Generally, proceeds from the disposition (sale or exchange) of separate property are considered separate property. However, the burden is on the spouse claiming the separate property to trace the funds from one asset to the next.

Property Acquired or Income Earned In a Separate Property State

Generally, personal property acquired as separate property or income earned while domiciled in a separate property state remains separate property.

Personal Injury Proceeds

In some states, personal injury proceeds are treated as separate property.

Appreciation of a Closely Held Business

This can be a tricky area. A closely held business owned by one spouse before the marriage usually appreciates during the marriage. How is the appreciation classified? If the community (husband and wife) receives fair compensation (by wages or otherwise) from the business, the appreciation is classified as separate property of the spouse who owned the business prior to the marriage. If there is no such fair compensation, the appreciation is classified as community property.

Assets Purchased With Separate and Community Funds

Here is another sticky area. In some states, if mixed funds are used to buy community property, proportionate interests in the purchased asset are held as a community and separate property, respectively. However, in other states, the character of the property used to acquire the first claim of ownership in the property (e.g., the down payment) determines who holds the title. In such a case, if mixed funds are used to acquire the initial interest, the property is held proportionately by the individual and the community based on contributions.

Example(s):  Husband and Wife buy a house for $150,000, paying the entire amount upon purchase. Of this amount, $50,000 is community property and $100,000 is the separate property of the Husband. Thus, the Husband and Wife own one-third of the home as community property and Husband owns the other two-thirds as separate property.

Certain Real Estate

Generally, real estate that is treated as community property under the laws of the state where the property is located is considered community property. However, special choice of law rules may apply when there is a conflict between the laws of the couple's home state and the law where the property is located.

When Do Special Rules Apply?

Arthur J. Gallagher employees should note that special rules apply in the following situations:

Certain Income

The IRS may disallow the benefits of community property law to a taxpayer with respect to any income if the taxpayer treats that income as if he or she alone were entitled to it, and he or she does not notify his or her spouse regarding the nature and amount of the income by the due date for filing the income tax return (including extensions).

Innocent Spouse Relief

Under certain limited circumstances, a spouse who had no knowledge or reason to know of community property income may be granted relief from tax liability for the income.

Nonresident Alien Spouses

If you are a U.S. citizen or resident and do not choose to treat your nonresident alien spouse as a U.S. resident for tax purposes, you may treat your community property the same as spouses living apart all year. The conditions that spouses living apart must meet are disregarded.

Spouses Living Apart All Year

Spouses who live apart all year are subject to certain reporting rules for filing returns for community income. These rules apply if:

•  You and your spouse are married to each other at any time during the taxable year
•  You and your spouse did not file a joint return for a tax year beginning or ending in the calendar year
•  You and/or your spouse had earned income for the calendar year that is community income
•  You and your spouse did not transfer, directly or indirectly, any of the earned income between yourselves before the end of the year (not counting payments for support or de minimis amounts)

If all of the conditions listed above are met, you must treat the property as follows:

•  Earned income — Treat earned income that is not trade, business, or partnership income as the income of the spouse who provided the services
•  Trade or business income — Treat trade or business income and deductions as those of the spouse who exercises substantially all of the management or control of the trade or business
•  Partnership income or loss — Treat a spouse's distributive share of partnership income or deductions as the income or loss of the spouse who is the partner
•  Separate property income — Treat investment income from the separate property of one spouse as income of that spouse
•  Social Security benefits — Treat Social Security benefits received during the year as the income of the spouse who received them
•  Other income — Treat all other community income (e.g., rents, dividends, interest, gains, and royalties) as community income

Why Does It Matter?

Ownership of marital property may be important because of tax and other ramifications.

Debts

Whether one spouse's property may be used to satisfy the debts of the other spouse varies based upon whether the debt is founded on contract or tort, was incurred before or during the marriage, and whether the non-debtor spouse's property is separate or community. Generally, community property is more likely to be used to satisfy the debt than the separate property of the non-debtor spouse.

Income Tax

In general, for income tax purposes, income and capital gains are divided equally between spouses regardless of who earned them, unless both spouses agree to divide them some other way. Similarly, deductions and losses are also shared. Upon the death of one spouse, all community property receives a new income-tax basis that reflects the value of the property at the first spouse's death. This basis adjustment (which may be up or down) applies to both halves of the community property — the half considered to be owned by the deceased spouse and the half considered to be owned by the surviving spouse.

Caution:  Arthur J. Gallagher employees should note that state community property laws affect both state and federal income taxes. These Arthur J. Gallagher employees should consult a tax specialist to determine how community property in their state affects their own situation.

Gift Tax

The IRS considers a gift of community property to a third party to be two gifts, one from each spouse. Therefore, if the gift is taxable under federal gift tax rules, each spouse is subject to tax on one-half the value of the gift. With minor exceptions, this is true even though the transfer of community property was made by one spouse completely independent of the other. No election to split the gift must be filed — it happens automatically.

Example(s):  Carol and Richard, a married couple who live in a community property state, give Carol's sister, Heather, a brand new car. The car cost $45,000. Carol and Richard can exclude $30,000 ($15,000 each) from federal gift tax under the annual gift tax exclusion (which is $15,000 in 2020). However, each may owe a gift tax of $7,500 (one-half of the $15,000 balance), if there are no other variables.

Estate Tax

One-half of the value of community property owned by a married couple is includable in the estate of the deceased spouse for estate tax purposes. However, the value of both spouses' shares of the property is stepped up or down to fair market value at the death of the first spouse. An alternate valuation date, six months after the deceased spouse's death, may also be used. As with any other form of property ownership, only the property that was actually included in the decedent's gross estate receives any basis revaluation.

Deductions from a decedent's gross estate (e.g., burial expenses, administrative expenses, and uninsured losses) are allowed only to the extent that these expenses relate to the decedent's interest in the community property. For example, if the decedent's community property farm were destroyed during administration, the estate would deduct one-half of the loss, reflecting one-half of the farm's value, which was included in the decedent's estate.

When Does the Marital Community End?

The marital community may end in several ways, including death, divorce, or separation. When the marital community ends, the community property is generally divided between the spouses.

Death of a Spouse

In community property states, each spouse is considered to own one-half of the community property. When one spouse dies, one-half of the property passes to the surviving spouse and one-half belongs to the deceased spouse's estate (and may then pass to the surviving spouse). The basis of both halves of the community property is adjusted to reflect the value of the property at the decedent's death. For this rule to apply, at least one-half of the community property interest must be includable in the deceased spouse's gross estate for estate tax purposes. 

Divorce or Annulment

The division of property incident to divorce or annulment does not result in a gain or loss. However, each spouse is taxed on one-half the community income for the part of the year before the community ends. Any income received after the marital community ends is separate income, taxable only to the spouse to whom it belongs.

An absolute decree of divorce or annulment ends the marital community in all community property states. A decree of annulment, even though it holds that no valid marriage existed, usually does not nullify community property rights arising during the so-called 'marriage.' Arthur J. Gallagher employees should check with an attorney in their state about this.

Separation

A decree of separation or of separate maintenance may or may not end the marital community. The court in the state issuing the decree may terminate the marital community and divide the property between the spouses. A separation agreement may divide the property between you and your spouse. It may provide that this property along with future earnings and property acquired will be separate property. Such an agreement may end the community. In some states, the marital community ends when the husband and wife permanently separate, even if there is no formal agreement. Arthur J. Gallagher employees should check with an attorney in their state about this.

Filing a Federal Income Tax Return

Joint Return Vs. Separate Returns

You may file separate returns if you and your spouse do not agree to file a joint return or if separate returns result in less tax. You should figure your tax on both a joint return and separate returns under the community property laws of your state. Compare the results to see which method saves you the most money.

However, before you decide to file separately, these Arthur J. Gallagher employees should be aware of the following:

•  If your spouse itemizes deductions, you should also itemize because you will not be allowed the standard deduction
•  In most instances, neither you nor your spouse will be allowed to take the credit for child and dependent care expenses
•  Neither you nor your spouse can take the earned income credit
•  Neither you nor your spouse can exclude interest income from Series EE U.S. savings bonds (may also be called Patriot bonds) used for higher education expenses
•  Neither you nor your spouse can take the credit for the elderly or disabled (unless you and your spouse lived apart all year)
•  You may have to include in your income more of the Social Security benefits (including railroad retirement benefits) you received
•  Neither you nor your spouse can deduct interest paid on a qualified student loan
•  Neither you nor your spouse can take the Hope credit or Lifetime Learning credit
•  Together, you and your spouse may have a smaller child tax credit than you would on a joint return
•  In most instances, neither you nor your spouse can take the exclusion or credit for adoption expenses

If you and your spouse file separate returns, each must report one-half of your combined community income and deductions in addition to your separate income and deductions. List only your share of community income and deductions on the appropriate lines of the return and attach a worksheet showing how you calculated those figures. If you do not attach a worksheet to your return, you should attach a copy of your spouse's return.

An extension of time for filing your return does not extend the time to file your spouse's return.