The IRS has continued to clarify how the unemployment benefits exclusion from income for 2020 under the American Rescue Plan Act works in community property states, now explaining the impact when the spouses file a joint return, as well as the impact of returns when filing married filing separate.[1]

There are nine community property states in the United States:

Washington
Idaho
Nevada
California
Arizona
New Mexico
Texas
Louisiana
Wisconsin

To oversimplify quite a bit, in those states by default income received by married individuals during marriage is considered income of the community, for which each spouse has a ½ interest. As well, under our federal system of government established by the U.S. Constitution, the law for ownership of property is an issue left to the various states.

The Internal Revenue Code generally respects such state law ownership rules when determining who will be taxed on income—you are taxed on income you own, other than income that was transferred to you after really being owned by another party (the assignment of income doctrine).

The American Recovery Plan Act of 2021 added subsection (c) to IRC §85 which works to exclude certain unemployment benefits from income. IRC §85(c)(1) is the provision we are interested in today:

(1) In general. In the case of any taxable year beginning in 2020, if the adjusted gross income of the taxpayer for such taxable year is less than $150,000, the gross income of such taxpayer shall not include so much of the unemployment compensation received by such taxpayer (or, in the case of a joint return, received by each spouse) as does not exceed $10,200.

A question arose almost instantly among practitioners in the community property states—does community property law result in each spouse receiving ½ of the combined unemployment compensation? The answer would seem to be yes, but now we have IRS confirmation—including how it impacts both a couple filing a married filing joint return and a couple that decides to file separate returns.

Let’s first look at a couple where only the husband was unemployed in 2020. That spouse collected unemployment benefits of $20,000 in 2020. Other than those unemployment benefits, the couple had gross income of $130,000. How much of their unemployment is taxable?

Well, if the couple resides in a non-community property state, that $20,000 of unemployment compensation would be the husband’s property. Thus, he would receive $20,000. $10,200 of that would be excluded from the couple’s income on the joint return, leaving $7,800 subject to tax.

But the result is changed, in the taxpayer’s favor, in a community property state. The newly published FAQ states:

If you file a Married Filing Joint return, when completing the worksheet, you should report half of your unemployment compensation and half of your spouse’s unemployment compensation on line 8 of the worksheet and your spouse reports the other half of your unemployment compensation and half of his or her unemployment compensation on line 9 of the worksheet. If your joint modified AGI is less than $150,000, you and your spouse can exclude up to $10,200 each. Do not exclude more than the amount of unemployment compensation you report on your Schedule 1, Line 7.[2]

If you follow those instructions, our married couple located in a community property state will be able to exclude the entire $20,000 of unemployment compensation, even though only a single spouse was unemployed.

IRC §85(c)(1) has the quirk that the level at which the exclusion is lost is the same for all filing statuses. So a married couple filing a joint return lose the exclusion at a modified adjusted gross income of $150,000. But if they each file their own return, swapping to married filing separate, each spouse now gets $150,000 of modified adjusted gross income.

But remember the bit about state law determining the ownership of income—that rule will apply when preparing separate returns, so that community income (including the unemployment) is split evenly between the spouses. But some may have worried the IRS might have treated the unemployment reported by the employed spouse as not having been received by her since it was her husband’s benefit.

However, as the married joint analysis should make clear, the IRS still views that portion of the unemployment compensation as received by the spouse who was employed all year. Thus the IRS arrives at the following conclusion when the community property couple files returns with a married filing separate status.

Because you live in a community property state, if you file a Married Filing Separate return, you report half of your unemployment compensation and half of your spouse’s unemployment compensation on your tax return and your spouse reports the other half of your unemployment compensation and half of his or her unemployment compensation on his or her tax return. You should exclude up to $10,200 on your tax return if your modified AGI is less than $150,000. Your spouse should exclude up to another $10,200 on his or her tax return if your spouse’s modified AGI is less than $150,000. Neither of you should exclude more than the amount of unemployment compensation you report on your Schedule 1, Line 7.[3]

It should be noted that not all income earned by married couples in community property states is community income. For various reasons (including a valid prenuptial agreement) some or all of the income earned by the spouses may be treated as separate property income. In that case, that income will be taxed to the spouse whose separate property it is. As well, there are different rules that determine what is separate vs. community income in different community property states.

[1] “Unemployment Exclusion Update for Married Taxpayers Living in a Community Property State,” IRS website, May 25, 2021, https://www.irs.gov/forms-pubs/unemployment-exclusion-update-for-married-taxpayers-living-in-a-community-property-state (retrieved May 26, 2021)

[2] “Unemployment Exclusion Update for Married Taxpayers Living in a Community Property State,” IRS website, May 25, 2021

[3] “Unemployment Exclusion Update for Married Taxpayers Living in a Community Property State,” IRS website, May 25, 2021