Spouses will need to following their state's laws to determine whether a particular item of income is separate or community income. Federal tax laws generally respect state laws in determining whether an item of income is community income and whether property is community or separate property, with some notable exceptions.
General Rules for Identifying Community IncomeCommunity property is property acquired while married and residing in a community property state and the property cannot be otherwise identified as separate property. Community income is the income generated by such community property.
General Rules for Identifying Separate IncomeSeparate property is property that was owned separately before marriage, property bought with separate funds or exchanged for separate property, and property that both spouses have agreed to convert from community property to separate property through a legally valid spousal agreement (a process called transmutation). Separate income is income generated by such separate property.
There are special rules for compensation income and retirement income.
Wages, Salaries and Self-Employment Income are Community IncomeCompensation in the form of wages, salaries, commissions, and self-employment are always treated as income belonging to the marital community. If spouses are filing separate federal tax returns, each spouse will report one-half of the total compensation income and one-half of the withholding on that compensation income.
Investment Income Could be Community Income or Could be Separate IncomeInterest, dividends, rent, capital gains and other income from investments could be community or separate income. The answer depends on the character of the property generating the income. If the property is separate property, then the income generated by that separate property is separate income. If the property is community property, then the income will be community income. A property could be a mix of separate and community property, in which case the income will be allocated as community property in the same proportion as the underlying property is community property.
Community Property Rules for Retirement and Pension IncomeIncome from individual retirement accounts (IRAs) and IRA-based plans such as SEP-IRAs and SIMPLE-IRAs is always separate income and is allocated to the spouse who owns the IRA.
Similarly, Social Security benefits are always separate income and is allocated to the spouse who receives the benefits.
Income from 401(k) plans, 403(b) plans, and other types of pensions may be a mix of separate and community income. Distributions from a retirement plan other than an IRA "will be characterized as community or separate income depending on the respective periods of participation in the pension while married ... and domiciled in a community property state" (Publication 555, page 4).
Basically, you will develop a ratio based on time participating in a retirement plan or pension. In the example found on page 5 of Publication 555, Henry worked and participated in his firm's pension or retirement plan for 30 years. For 15 of those years, he was married and living in a community property state. So 50% of the pension income (15 years divided by 30 years) is community income, and the remaining 50% is Henry's separate income. On his separate return, Henry would report 75% of his pension distributions (half of the 50% community income plus all of the 50% separate income). Henry's spouse would report half of the community pension income (which would work out to 25% of the total pension received in this example).
If you receive a lump-sum payment from a pension plan, you might be eligible to use the optional 10-year tax calculation method that disregards community property factors. Refer to Publication 575, Pension and Annuity Income, and the instructions for Form 4972.
Alimony and Community PropertyIf one spouse is paying alimony or separate maintenance to another spouse prior to their divorce being finalized, then the alimony is taxable to the extent the payments exceed 50% of the spouse's imputed community income. The reason for this is that each spouse is considered to already own half of the community income, so transfers of those amounts are non-taxable. Amounts in excess of the community income allocations are income to the receiving spouse and deductible to the paying spouse.
Income from Separate Property is Sometimes Community IncomeIn Idaho, Louisiana, Wisconsin, and Texas, income generated by separate property is still considered community income. So in these states, the only income that will be classified as separate income are distributions from an IRA, Social Security benefits and alimony.
By contrast, in Arizona, Nevada, New Mexico, and Washington, income from separate property is considered separate income.