Certain States Recognize Community Property
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin are states where assets may be held as community property. (Alaska also has an “opt in” option for assets to be treated as community property). Estate planning in those states requires an understanding of what community property is and how it is treated for tax and dispositive purposes.
What Is Community Property?
Community property is generally defined to be property acquired during a marriage in a community property state. It doesn’t matter if that property is titled in the name of one spouse or the other – or in the name of both spouses. As a general rule, if the property is acquired during marriage, regardless of how title is held it is treated as community property.
Community property must be contrasted with separate property – which is typically defined as property acquired before marriage, property acquired by gift or property acquired by inheritance.
Similarly, debts incurred by a married couple are typically defined as community property debts. Debts acquired prior to marriage are treated as separate property debts.
Married couples can “transmute” community property to separate property and vice versa. Generally, a signed writing changing the character of the property is required. The nature of a debt as separate or community can also be transmuted. A prenuptial or postnuptial agreement can also re-define what will be separate and community property assets or debt in the context of a marriage.
Can Separate Property Ever Become Community Property?
As mentioned above, a person can transmute separate property to community property, typically by a signed writing. However, there are other circumstances where a community property element can seep into what is otherwise a separate property assets.
Assume wife comes into a marriage with a newly created business worth $100,000. Because the business was created prior to marriage, it is wife’s separate property. However, assume also that wife works in the business during marriage, and through her efforts increases the value of the business to $10,000,000. That increase in value during the marriage – $9,900,000 – can be classified as community property if the couple divorces. (Oftentimes, the community property portion of the business can be offset by earnings – which would be community property – taken by wife during the marriage.) Eliminating this community property element in a separate property business is oftentimes an important focus of a prenuptial agreement.
How Is Community Property Disposed of As Part of an Estate Plan?
When property is community property, it means that each spouse has an undivided 50% interest in that property. In effect, when a spouse dies, he or she has the ability to dispose of that spouse’s community property share of each assets – but not the other spouse’s community property share.
Many married couples create a joint revocable living trust. They transfer all of their assets to the joint revocable living trust during their lifetimes. When the first spouse dies, his or her half of the joint revocable living trust becomes irrevocable – and disposes of the first to die’s assets. Yet, a joint revocable living trust often includes a provision that allows for pro rata or non-pro rata distribution of assets. What that means is that, should the trustee desire, so long as equal value is allocated to the first to die and second to die’s respective shares of the joint revocable living trust, 100% of a community asset can be allocated to the first to die’s share of the joint revocable living trust or to the second to die’s share of the joint revocable living trust.
Define What Is Community (or Separate) Property to Avoid Arguments at Death
When couples have children by different marriages, if what is community (or separate) property is not clearly identified, the seeds have been sown for a fight when the first spouse dies. The children of the first to die will be in direct conflict with the children of the survivor in deciding whether assets are community or separate property. To avoid these conflicts, the couple should strongly consider entering into a post-nuptial agreement which clearly defines the nature of each asset.
How is Community Property Estate Taxed?
Because 50% of the value of a community property asset is subject to estate tax when the first spouse in a couple dies, that 50% will be subject to estate tax. Similarly, 50% of community property debts will be allowed as estate tax deductions on the first to die’s estate tax return.
Basis Step-Ups at Death for Community Property
“Basis” is what is used to measure capital gain on the sale of an asset. If an asset is purchased for $10 (its “basis”) and sold for $14, there is gain of $4 that is subject to capital gains tax (sale price – basis = gain). Heirs inherit assets that are subject to estate tax when a person dies with a basis equal to fair market value at the time of the decedent’s death. In the forgoing example, if the owner of the asset dies, his heirs would receive a basis “step-up” to $14. If the asset is sold for $14, there is no capital gain.
There is a special rule for community property assets – when the first spouse dies, even though only 50% of the community property asset is subject to estate tax, 100% of the basis gets stepped-up. This is an important advantage to holders of appreciated assets at death – if the asset is treated as community property, there will be a “double” basis step-up for the heirs.
If an ill spouse is married to a person who owns separate property, that person may desire to transmute the separate property to community property in order to take advantage of the double basis step-up on the death of that person’s ill spouse. The double basis step-up is generally not allowed, however, if the person “giving” the asset to the ill spouse (by declaring it to be community property) inherits that asset back because of the ill spouse’s death within one year of the transmutation. However, if the person declares the asset to be community property and then both spouses contribute the asset to (for example) a limited liability company, and when the ill spouse dies he or she leaves the interest in the limited liability company to a trust for the surviving spouse, the double basis step-up may be available. Why? Because the asset given didn’t come back – what came back was an interest in a limited liability company that owned the asset given. And the giver didn’t inherit anything – instead, the interest in the limited liability company owning the asset passed to a trust for the giver. Following this approach, the technical requirements that would deny the double basis step-up are not present, and many accountants of the surviving spouse would reflect the double basis step-up for the limited liability company (and the asset given that is owned by the limited liability company by making a Section 754 election on the limited liability company’s income tax return).
Of course, if an asset has declined in value, then on death the heirs will receive the asset with a basis step-down. In that circumstance, the ill spouse who owns the property might join with the other spouse to transmute the asset to joint tenancy. There is no double basis step-down (or step-up, for that matter) for joint tenancy property. By re-titling an asset with value less than basis to joint tenancy before a spouse dies, the double basis step-down can be avoided (only the 50% interest of the spouse who dies will be stepped down). Similarly, each spouse can declare the community property asset to be 50% each of their separate property; again, the basis step-down would be limited to the 50% owned by the first to die (and in this case the first to die’s 50% share of that asset would pass to the heirs of the first to die). Other options available to the ill spouse who owns an asset with value less than basis include (a) selling the asset prior to death (to recognize the loss before it is extinguished by the basis step-down) or (b) giving the asset to the other spouse as his or her separate property (avoiding the basis step-down altogether). The rule that avoids the benefit of a double basis step-up if an asset is given and inherited back within one year does not apply in this context. However, if the first to die spouse has different heirs than the surviving spouse, he or she may not want to simply give a valuable asset away to the surviving spouse (effectively reducing what the first to die’s heirs might inherit).
Interests in “ERISA” Plans Cannot Be Community Property
Case law makes it clear that there is no community property interest in “ERISA” plans. That is because community property is state law, while ERISA is a federal law – and federal law pre-empts state law.
“ERISA” plans generally include 401(k) plans, pension plans, profit-sharing plans, 403(b) plans and Keogh plans. IRAs are not ERISA plans.
Federal law defines the rights of a surviving spouse to inherit an interest in an ERISA plan. In most cases, the surviving spouse of the participant in an ERISA plan is entitled to inherit at least 50% of the plan assets. In effect, the spouse is granted (by federal law) a 50% interest in the plan in this fashion.
Because there is no community property interest in an ERISA plan, 100% of the value of that plan is shown on the estate tax return of the participant first to die. Contrast that to an IRA, where only 50% of the value of the plan is shown on the estate tax return of the participant first to die. Even though assets of an IRA can be treated as community property on a first death, there is no basis step-up allowed for IRA assets (they are “income in respect of a decedent” for which a basis step-up is prohibited) so no income tax advantage is available.
