Texas Community Property Income Splitting Capital Gains 101

Texas community property rules touch almost every line of a married couple’s federal return. If you live in Texas, earnings and most income during the marriage are generally shared between spouses. That affects how income is reported when married filing separately, how capital gains are allocated, who owes self employment tax, and how basis works when a spouse dies. This guide explains Texas community property income splitting and Texas community property capital gains with plain English examples, federal references, and practical steps for married couples and small business owners to cut tax exposure and avoid filing errors.

Texas community property basics

Texas is a community property state. Under state law, property and income acquired by either spouse during marriage is generally community property unless a statute treats it as separate property. See Texas Family Code Section 3.002 for the core definition and framework. You can read the statutory text at Texas Family Code 3.002.

Separate property commonly includes assets owned before marriage, gifts and inheritances to one spouse, and certain personal injury recoveries. Community property usually includes wages, income from community assets, and assets purchased with community funds. Texas spouses can also sign written agreements to change how an asset is classified. You can partition community property so that each spouse owns separate interests, or convert separate property to community property by written agreement. See the statutes on conversion and partition at Texas Family Code Chapter 4 and Texas Family Code Section 4.203.

These state rules feed directly into federal tax reporting. The IRS uses state property law to determine who owns income and who reports it. In a community property state, that means how you report income and deductions on your federal return depends on whether the item is community or separate. The IRS summarizes the system in Publication 555, Community Property.

How filing status affects income splitting

Filing status drives how community income appears on your federal returns. In Texas, most married couples choose Married Filing Jointly because it usually produces lower tax and preserves credits like the child tax credit and education credits. The IRS compares the filing statuses in Publication 501. Married Filing Separately can sometimes make sense for very specific goals, but it removes many credits and often increases tax. On top of that, married filing separately in a community property state adds an allocation step that many couples are not ready for.

When spouses file separate federal returns and are domiciled in Texas, each spouse generally must report half of the community income and all of his or her separate income. This is the core Texas community property income splitting rule the IRS applies to separate returns. The IRS requires a specific attachment to show the allocation. You must include Form 8958, Allocation of Tax Amounts Between Certain Individuals in Community Property States, with each separate return. If Form 8958 is missing or inaccurate, expect an IRS notice or e file error. Publication 555 gives more detail about when and how to split community income.

A simple example of separate returns with community income

Assume Spouse A earns wages and Spouse B earns investment income, all during the marriage while living in Texas. If they file separately, each spouse generally reports half of the community wages and half of the community investment income. Each still reports his or her own separate income, if any. Withholding on community wages is also treated as community and is usually split between the two separate returns in the same proportion. Form 8958 provides a worksheet to show the allocation line by line.

If the same couple files jointly, no allocation is needed because both spouses are reported together on a single return. That is one reason joint filing is often simpler and often reduces the total tax compared with two separate returns.

What counts as community income on federal returns

Most income produced during the marriage while domiciled in Texas is community income. For federal reporting, common items include wages, interest, dividends, rents, and net profit from a sole proprietorship. When married filing separately, each spouse usually reports half of these community items. The IRS explains each category in Publication 555.

Separate income remains separate. Examples include interest on separate property held since before marriage and distributions from an IRA that is owned by only one spouse. Publication 555 confirms that IRAs and certain education accounts are treated as separate property for this purpose, and the income is taxable to the owner spouse even in a community property state.

Wages, withholding, and estimated payments

Wages earned during the marriage are usually community income in Texas. If you file separate returns, the wage income is split fifty fifty as community income unless there is a valid agreement or exception. The associated federal income tax withheld from those wages is also community, so the withholding is usually divided between the two separate returns. This is where Form 8958 is essential. The IRS uses the schedule to match your allocation and withholding with the W 2 data.

Estimated tax payments made from community funds are usually community as well. If only one spouse makes estimated payments but the funds came from community income, those payments are generally split across both separate returns. Keep good records so that your allocation matches the bank activity and the payments credited by the IRS.

When you file jointly, the split is not needed. All wage income and withholding are reported on one combined return, and credits and deductions are computed once for the couple.

Small businesses and self employment tax

Texas small business owners face a unique twist. For income tax, net profit from a sole proprietorship that is community property is split between spouses if they file separate returns. For self employment tax, the IRS looks at who actually carries on the trade or business. Publication 555 explains that self employment tax is imposed on the spouse who runs the business, even though the income may be community for federal income tax purposes. That means only the operating spouse gets credit for Social Security and Medicare contributions tied to that business.

Practical steps for sole proprietors in Texas include keeping separate books for the business, tracking who works in the business, and documenting whether startup capital and asset purchases came from separate funds or community funds. If separate funds are used to start or expand the business, tracing those contributions can protect separate interests. Texas law allows written agreements to convert or partition property interests, and those documents can help avoid conflict later. See Texas Family Code Chapter 4 for the mechanics of written agreements.

Partnerships and S corporations raise additional questions. A partnership distributive share that is community will generally be split for income tax when filing separately, but self employment tax follows partnership rules, which may include guaranteed payments that are subject to self employment tax for the partner who receives them. S corporation wages are W 2 wages to the shareholder employee and are usually community if earned during marriage, while S corporation dividends or distributions can be community or separate depending on ownership and the source of funds. The key is careful documentation and clear ownership records so that the correct spouse pays the correct tax at the correct time.

Texas community property capital gains

Gains and losses retain the character of the asset that is sold. If community funds purchased the investment during the marriage, then the gain is community and is generally split if you file separately. If the asset is separate property, the gain remains separate. Getting the classification right matters on your federal return and in future planning.

For married filing separately in Texas, community capital gains and losses are normally divided equally between the spouses on each separate return. Capital losses are subject to federal limits on each return. If you are filing separately, your ability to use capital losses can differ, which can affect the timing of sales and how you allocate gains and losses on Form 8958.

Home sales add another layer. The federal home sale exclusion can apply to community property if the ownership and use tests are met. Publication 523 describes examples that involve community property states. You can find those examples in Publication 523, Selling Your Home. If the home is community property and you qualify for the exclusion, the gain calculation and allocation should follow the community rules for your filing status.

Example of allocating community investment gains

Assume spouses living in Texas bought a taxable investment account during the marriage with community funds. They sell stock for a long term gain. If they file a joint return, the gain is reported once on the joint return. If they file separate returns, each spouse generally reports half of the long term gain as community income. If one spouse also sold separate property stock, that gain stays with the owning spouse and is not split. The same concept applies to capital losses, subject to the federal limits on each return.

Basis and the community property step up at death

Community property can provide a valuable basis adjustment when a spouse dies. In a community property state, if at least one half of the community interest is included in the decedent’s gross estate, the entire community property usually receives a basis step up to its fair market value at the date of death. In plain terms, both halves of community property typically receive a new basis at death, not just the decedent’s half. The IRS discusses this in Publication 555, with general basis rules covered in Publication 551, Basis of Assets.

This rule can wipe out built in capital gains for assets held until the first spouse’s death. It applies to community property that meets the inclusion test, which is one reason asset titling, recordkeeping, and estate planning language should be reviewed with care. Publication 523 includes examples involving home sales after a spouse’s death, which can help you see how the basis adjustment plays through in a later sale.

Illustration of a community property basis step up

Assume a Texas couple owns community property stock with large unrealized gains. One spouse dies while they still hold the stock. If at least half of the community interest is included in the decedent’s estate, both halves of the stock generally receive a basis step up to fair market value at the date of death. If the survivor sells soon after, there may be little or no taxable gain on that sale. In contrast, if the same stock were separate property of the decedent, only that portion would receive a basis step up. Getting the classification right and coordinating with an estate plan can change real tax dollars over time.

Not every asset is eligible for a basis step up. Retirement accounts like IRAs do not receive a basis step up at death for the account itself. That is one reason you should understand which assets are community property and which are separate property. The rules can be nuanced, so a coordinated plan with a CPA and an estate attorney is wise when large assets are involved.

Retirement accounts and allocation

The IRS treats IRAs and Coverdell education accounts as separate property for federal income tax purposes even in a community property state. Distributions from an IRA are taxable to the spouse whose name is on the account. Publication 555 confirms that character. This matters if you file separate returns. You cannot simply split IRA distributions fifty fifty as community income. By contrast, pension or annuity payments may have different treatment depending on the source and state law, so a personalized review is smart before filing.

Married filing jointly versus separately in Texas

Many Texas couples ask whether they will save money by filing separately to split income. The answer is often no. Married Filing Separately can increase tax and can remove credits and deductions that would be available on a joint return. It also requires careful Texas community property income splitting on Form 8958, which adds time and risk of errors. Married Filing Jointly often provides a larger standard deduction and may allow credits that are not available to separate filers. Publication 501 lists the differences and the common tradeoffs.

Topic	Texas MFJ	Texas MFS
Reporting community income	All income on one return	Split community items fifty fifty using Form 8958
Common credits	Often available if eligible	Many credits limited or unavailable
Withholding and estimates	Reported once	Usually split across both returns
Complexity	Lower	Higher due to allocation rules

Practical tips to cut tax and avoid errors

Pick the filing status that supports your goals. Prepare a joint and separate scenario before choosing. The joint scenario often wins on total tax and credits. Run a side by side comparison using Publication 501 rules and include the true cost of managing two separate returns with Form 8958 allocations.

If you must file separately, prepare Form 8958 carefully and attach it to each return. Split community income, deductions, and credits consistently. Align W 2 withholding and estimated payment allocations with the income split. Mismatches are a common trigger for notices.

Small business owners need clean documentation. Keep business books current. Track who works in the business so self employment tax lands on the correct spouse. Keep a file that shows whether startup capital and asset purchases came from separate funds or community funds. If you want to change the character of an asset, use a written agreement that meets Texas Family Code requirements.

Plan capital gains timing alongside basis planning. Because community property can receive a full basis step up at death, the decision to sell now versus later can change tax results. Coordinate investment sales with estate planning, especially when the asset has large unrealized gains and the couple expects to hold long term. Publication 523 and Publication 551 provide practical examples of basis adjustments and sales after a death.

Do not misclassify IRA distributions. IRAs are separate property for these rules, so the owner spouse reports the income. The same goes for certain education accounts. Publication 555 is the key reference for these distinctions.

Trace separate funds when they are used inside a community marriage. If one spouse uses separate property to buy business assets or investment property, keep records that allow clear tracing. That can protect a separate interest during life and at death, and it can reduce disputes and potential extra tax later. The Texas Family Code allows formal partition and conversion agreements to make these classifications clear.

Common pitfalls for Texas couples

Omitting or incorrectly preparing Form 8958 when filing separate returns is a frequent error in community property states. The IRS has clear expectations and will send a notice if the allocation is missing or does not match income statements. See About Form 8958 for instructions.

Expecting a split to always reduce tax is another trap. Married Filing Separately often removes credits and deductions. Publication 501 lists many of these limits. Always model both scenarios before filing.

Misclassifying IRA or retirement distributions as community income can cause both reporting and penalty problems. Publication 555 states that IRAs are separate for these purposes and distributions are taxable to the owner spouse.

Failing to document separate funds or not using formal agreements when changing property character can create disputes in divorce and probate and can increase taxes. Texas law provides pathways for written conversion and partition agreements. See Texas Family Code Chapter 4 for guidance.

Assuming Texas provides a community property trust like Alaska does is a misconception. Texas allows written conversion and partition agreements but does not have the same statutory community property trust framework that some other jurisdictions use. Get advice before using an out of state trust approach.

Real world examples

Higher earner with community wages and separate rental property. A couple lives in Texas all year. Spouse A earns wages that are community. Spouse B owns a rental house acquired before marriage that produces a loss. If they file separately, each spouse reports half of the community wages and half of the wage withholding. The rental loss stays with Spouse B if the rental is truly separate, subject to passive loss rules. If they file jointly, all items are reported once and the passive loss rules are applied on the joint return. In many cases, the joint approach yields a better result because thresholds for passive loss allowances and credits are less restrictive.

Sole proprietor and a stay at home spouse. Spouse A runs a sole proprietorship. The profit is community for income tax, so it would be split if they file separately. But the self employment tax belongs to Spouse A only, because that spouse carries on the trade or business. If they file separate, they need to show that split on Form 8958 and track the self employment tax on Spouse A’s return. Estimated tax payments made from community funds are generally community as well, which means those payments should be split unless the record shows otherwise.

Investment account and the community property step up at death. A Texas couple owns a brokerage account purchased during marriage. One spouse dies. If at least half of the community interest is included in the decedent’s estate, the entire community account receives a basis step up to fair market value at the date of death. If the survivor sells soon after, there may be little or no taxable gain. Publication 551 explains how to compute basis, and Publication 523 has examples of sales after a spouse’s death for homes. For securities and other investments, the concept is similar. The result can be large capital gains savings for the survivor when assets are held through the first spouse’s death.

Checklist before you file

Identify your Texas domicile for the year. If you lived in Texas during the year, community rules likely apply to income acquired during that period.

Decide on filing status after a side by side comparison. Include the loss of credits under Married Filing Separately and the added time and risk of allocation mistakes.

If filing separately, draft Form 8958 early. Allocate wages, investment income, deductions, withholding, and estimated payments across both returns in a consistent way.

Confirm how self employment tax will be handled. The operating spouse in a sole proprietorship owes the self employment tax even if the income is split for income tax. Adjust estimated payments accordingly.

Review capital assets for classification and basis. Decide whether near term sales or holding periods should be adjusted based on community property step up rules. Coordinate with your estate plan.

Review retirement accounts. Treat IRAs as separate and confirm who reports distributions.

Update or create written conversion or partition agreements if you want to change property character. Use Texas Family Code compliant documents.

Frequently asked questions

Do we split W 2 wages if we file jointly?

No. When you file a joint return, you report all income and withholding on one combined return. The community split applies when spouses file separate returns while domiciled in a community property state. See Publication 555 for details.

When does Form 8958 apply in Texas?

Form 8958 is required when spouses who are domiciled in a community property state file separate federal returns. The form shows how you allocated community income, deductions, credits, and withholding. The IRS page for the form is at About Form 8958.

Are IRA distributions split as community income?

No. Publication 555 states that IRAs are treated as separate property for federal income tax purposes. Distributions are taxable to the account owner spouse, not split across spouses as community income.

If my spouse dies, do all assets get a basis step up?

No. Community property can receive a full basis step up if at least half of the community interest is included in the decedent’s estate. Separate property owned by the decedent generally receives a step up for that portion only. Retirement accounts like IRAs do not receive a basis step up for the account itself. See Publication 551 and Publication 555 for the mechanics and examples.

Can we convert separate property to community property in Texas?

Yes. Texas allows spouses to use written agreements to convert separate property to community property or to partition community property into separate interests. The formalities are covered in Texas Family Code Chapter 4.

Will Married Filing Separately lower our student loan payment?

Sometimes separate filing can affect income driven repayment calculations, but it can raise your federal tax and remove credits. We recommend running both tax scenarios first, then weighing any payment change against the added tax and complexity from community allocations.

How do we allocate withholding when only one spouse worked?

If the wages and withholding are community, they are generally split between spouses on separate returns. Use Form 8958 to show the allocation. Publication 555 explains this approach for community states.

When to call a professional

Households with small businesses, partnerships or S corporation interests, or sizable investments benefit from a short planning call before filing season. Texas community property rules change which spouse reports income when filing separately, who owes self employment tax, how withholding is allocated, and whether a written conversion or partition makes sense. They also change the long term plan for selling assets versus holding for a basis step up at death. Alviso, CPA is a Texas based practice that helps married couples and owners of closely held businesses plan with confidence. If you have questions about Texas community property income splitting, Texas community property capital gains, or a basis step up for a surviving spouse, book a tax planning session so we can tailor the rules to your facts.

Resources you can trust

IRS Publication 555, Community Property. Allocation rules for income, deductions, credits, and death of a spouse basis rules. Read Pub. 555

IRS About Form 8958. Allocation schedule required for separate returns in community states. About Form 8958

IRS Publication 501, Filing Status. Who can file jointly, separate filing tradeoffs, credits and limits. Read Pub. 501

IRS Publication 551, Basis of Assets. Basis rules, adjustments, and examples. Read Pub. 551

IRS Publication 523, Selling Your Home. Community state examples and post death sale rules. Read Pub. 523

Texas Family Code Section 3.002 and related chapters on conversion and partition agreements. Community property definition and agreements to convert or partition

A short wrap up

Texas community property rules affect income reporting, capital gains, self employment tax, and basis at death. If you file separately, community income is usually split and you must attach Form 8958. If you run a business, self employment tax belongs to the spouse who carries on the trade or business even when profits are community. Community property can offer a full basis step up at a spouse’s death, which can remove large capital gains for survivors. The most common wins come from choosing the right filing status, preparing a careful allocation if you file separately, documenting business funding and ownership, and coordinating capital gains timing with estate planning. If your facts include a Texas small business, large investments, or mixed separate and community property, schedule time with Alviso, CPA to put the rules to work for your family.

Compliance note. This article summarizes general federal and Texas rules reflected in the cited IRS publications and Texas statutes. It is not tax or legal advice. For specific situations that involve large assets, estate planning, or business interests, consult a CPA and an estate attorney.