Every family law attorney knows that the state’s property regime shapes how the marital estate is divided. What’s easy to overlook is how much that same regime shapes the tax consequences of the divorce, from how income is reported during separation to which spouse walks away with a hidden tax bill.
This article compares community property and equitable distribution states from a tax perspective and highlights the issues most likely to affect your clients’ after-tax outcomes.
The Two Systems at a Glance
Community property states generally treat most income earned and property acquired during the marriage as owned equally by both spouses, regardless of whose name is on the paycheck or title. There are nine traditional community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (which uses a similar marital property system). A handful of other states, including Alaska, Kentucky, South Dakota, Tennessee, and Florida, allow couples to opt in to community property treatment through an agreement or trust.
Equitable distribution states, which make up the rest of the country, divide marital property in a way the court considers fair. Fair doesn’t always mean equal. During the marriage, ownership generally follows title and whoever earned the income.
For federal tax purposes, the IRS looks to state law to determine who owns income and property. That’s why the same facts can produce different federal tax results in different states.
Issue 1: Reporting Income During Separation
The biggest practical difference shows up when spouses file married filing separately (MFS) during a pending divorce.
In an equitable distribution state, each spouse generally reports his or her own wages, business income, and income from property held in his or her name. That’s relatively straightforward.
In a community property state, each spouse generally must report half of all community income, plus all of his or her separate income, and each claims half of the tax withheld from community wages. Form 8958 is used to allocate the amounts between the two returns. The result can surprise a client: a non-working spouse filing separately may owe tax on half of the other spouse’s salary.
Timing matters, too. States differ on when the community ends. In some community property states, such as California, earnings after the date of separation are generally separate property. In others, including Texas, the community generally continues until the divorce is final. That can mean a full additional year (or more) of split income reporting in a drawn-out case.
Another wrinkle: in Idaho, Louisiana, Texas, and Wisconsin, income from separate property (such as dividends on an inherited account) is generally treated as community income, while other community property states treat it as separate. Your client’s return may need to reflect that distinction.
Issue 2: Relief When One Spouse Controls the Income
Community property rules can create real hardship when one spouse earns the income and the other never sees it. Internal Revenue Code Section 66 offers several forms of relief:
- Spouses living apart all year. If the spouses lived apart for the entire calendar year, didn’t file jointly, and didn’t transfer earned income between them, each may be able to report his or her own earned income rather than splitting it.
- Spouse who acted as if solely entitled. The IRS can deny community property benefits to a spouse who treated community income as his or her own and failed to notify the other spouse.
- Equitable relief. A spouse who didn’t know about the other’s community income may request relief from tax on that income, using Form 8857.
These provisions are separate from, and in addition to, the innocent spouse relief available for joint returns.
Issue 3: Dividing Property Tax-Free, but Not Tax-Equal
Under Section 1041, transfers of property between spouses, or between former spouses incident to divorce, are generally not taxable. That rule applies in every state. But the receiving spouse takes the transferring spouse’s tax basis, which means built-in gains move with the asset.
Consider two assets that look equal on a settlement spreadsheet:
| Asset | Fair market value | Tax basis | Built-in taxable gain |
| Brokerage account | $300,000 | $100,000 | $200,000 |
| Cash savings | $300,000 | $300,000 | $0 |
Both are worth $300,000 today, but the spouse who takes the brokerage account inherits a $200,000 gain. On an after-tax basis, the division isn’t equal at all. This issue arises in both systems, but it’s especially pointed in community property states where the default is a 50/50 split of value.
The same concept applies to depreciated rental property (with potential depreciation recapture), business interests, stock options, and deferred compensation.
Issue 4: Clients Who Moved Between States
Property generally keeps its character based on where the couple lived when it was acquired. A couple who earned income in Texas and later moved to an equitable distribution state may still own community property. Some community property states, such as California and Arizona, also apply quasi-community property rules to property acquired while living elsewhere. For tax purposes, characterization drives both income reporting and basis questions, so it’s worth mapping out the couple’s residence history early.
Issue 5: The Marital Home
Section 121 allows a taxpayer to exclude up to $250,000 of gain on the sale of a principal residence ($500,000 for a joint return if requirements are met). Divorce often complicates the ownership and use tests. Helpful rules include:
- A spouse who receives the home in a Section 1041 transfer includes the transferring spouse’s ownership period.
- A spouse who moves out may still be treated as using the home while the other spouse lives there under a divorce or separation instrument.
- Timing a sale before or after the divorce can change whether the couple qualifies for the $500,000 joint exclusion or two separate $250,000 exclusions.
Issue 6: A Hidden Benefit in Community Property States
In community property states, when one spouse dies, both halves of community property generally receive a basis adjustment to fair market value, not just the decedent’s half. That can wipe out large built-in gains. It’s not a divorce benefit, but it matters when a spouse is seriously ill during a pending divorce, or when clients are weighing whether to finalize now or later.
What Stays the Same Everywhere
Several key rules apply regardless of the property regime:
- Filing status is determined by marital status on December 31.
- Alimony under divorce or separation agreements executed after 2018 is not deductible by the payer and not taxable to the recipient for federal purposes.
- Child support is never deductible or taxable.
- Retirement plans are divided through a QDRO (for employer plans) or a transfer incident to divorce (for IRAs) to avoid tax and penalties.
- Joint return liability is joint and several, and the IRS isn’t bound by a divorce decree that assigns tax debt to one spouse.
An Attorney’s Tax Checklist by Property Regime
- Confirm the couple’s state of residence and residence history for the entire marriage.
- In community property states, determine when the community ends under state law and plan for split income reporting on separate returns.
- Decide early whether to file jointly or separately for the current year, and have a tax professional model both options.
- Identify the tax basis of every significant asset, not just its value, and compare after-tax values.
- Address responsibility for prior-year tax liabilities, refunds, and future audit adjustments in the settlement agreement.
- Evaluate whether Section 66 or innocent spouse relief may be available to your client.
- Bring in a tax professional before the settlement is signed, not after.
Partner With a Tax Professional
LP Tax & Bookkeeping Pros works alongside family law attorneys to analyze the tax side of divorce: modeling filing status options, allocating community income, evaluating asset basis, and representing clients before the IRS when tax debts or audits arise. We’re a resource for you and your clients, and we stay in our lane: taxes.
This article is for general informational purposes only and is not tax or legal advice. Tax rules change frequently and every situation is different. Please consult a qualified tax professional before acting on any of the information above.
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