If you are married, a good estate planning attorney will ask you during the information gathering process whether you have ever lived in a community property state. This is because community property retains its character as such when a couple moves to a state with different marital property laws. Your estate planning attorney needs to know this because it can have an impact on what is included in your estate when you die and to what extent the property received a step up in basis when you die.
In common law states, typically the surviving spouse may elect against the will of the predeceasing spouse and get what would be the intestate share. This is usually around 1/3 of the estate. In some common law states, the “estate” against which the survivor may elect is the "augmented estate", which can include non-probate assets such as a revocable trust. In other states, the survivor may only elect against the probate estate.
About half of the separate property states (such as Tennessee) have “tenancy-by-the-entirety” or “TBE.” This form of ownership is like joint tenancy, except it is only available to married couples. In some states TBE is only available for real property. In other states, such as Tennessee, TBE is available for both real and personal property (like an investment account). A couple must act together in order to encumber or sell TBE property.
TBE property cannot be reached by a spouse's separate creditors. TBE property can be reached by creditors of both spouses. If the spouse without creditor issues dies, the property automatically vests in the spouse with creditor issues and can be reached by the surviving spouse's creditors at that time. Accordingly, TBE property offers cheap but limited creditor protection.
The community property system has been adopted by nine states: Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin. The U.S. Territories of Guam and Puerto Rico are also community property jurisdictions. In Alaska, spouses may create community property by entering into a community property agreement or by creating a community property trust. In Tennessee, spouses may create community property ONLY by creating a community property trust.
The theory underlying community property is analogous to that of a partnership. Each spouse contributes labor (and in some states, capital) for the benefit of the community, and shares equally in the profits and income earned by the community. Thus, each spouse owns an automatic 50% interest in all community property, regardless of which spouse acquired the community property. The character of the property is determined based on the domicile of the parties and the source of funds. The manner in which the property is titled is not dispositive. In community property states, property acquired during the marriage is presumed to be community property absent evidence of a contrary intent or agreement. Spouses may also hold separate property, which they solely own and control. Gifts, inheritances and property owned prior to the marriage are considered separate property.
Each spouse has an equal right to manage community property but has exclusive management rights over their own separate property. Upon divorce, the court has the power to divide community property, but may not reallocate separate property. In California, community property must be divided equally.
At death, each spouse has a right to transfer only his or her one-half of the community property. This effectively gives the surviving spouse an automatic 50% share of the community property estate.
Most couples go through life not giving any thought to the character of their assets as separate property or community property, and not understanding that in some cases they have a choice, but being intentional when it comes to characterization of property can generate substantial tax savings. From a capital gains tax perspective, it is usually better to have community property. This is because at death, the basis of the property of the decedent is stepped up (or down) to the fair market value of the property at date of death (or alternate valuation date). Because most property appreciates in value over time, usually this results in a step up in basis, which is a good thing. In common law states, only the property in the decedent's taxable estate gets the step up (or down) in basis. However, in community property states, both halves of the community property receive a step up (or down) in basis.
Here is how this works: Let's say a couple owns property that they paid $200,000 for decades ago, giving them a basis of $200,000. (The basis might be higher after adding costs of improvements and other things, but let's just keep things simple for this example.) The property is now worth $2,000,000. If they were to sell it tomorrow, they would incur capital gains tax on $1,800,000 ($2,000,000 minus $200,000.)
If, instead, one of them were to die tomorrow and it is NOT owned as community property, the decedent's half of the property, valued at $1,000,000 (half of $2,000,000), would get its basis stepped up from $100,000 (half of $200,000) to $1,000,000 (half of $2,000,000). That would bring the total basis up from $200,000 to $1,100,000 (decedent's half at $1,000,000 stepped-up basis plus the surviving spouse's basis of $100,000). If the surviving spouse were to sell the property shortly thereafter for date of death value (or alternate valuation date value), he or she would only have to pay capital gains tax on $900,000 ($2,000,000 sale price less $1,100,000 basis). Clearly it was worth waiting to sell.
But the surviving spouse would have fared even better had the property been characterized as community property. If one of them were to die tomorrow and it had been owned as community property, the entire property would get its basis stepped up from $100,000 to $2,000,000. If the surviving spouse were to sell the property shortly thereafter for date of death value (or alternate valuation date value), he or she would have ZERO capital gains tax to pay ($2,000,000 sale price less $2,000,000 basis is $0 capital gain).
And THAT is why it is usually better to own property as community property if you have the choice.
If you are in a community property state, do not assume that you are home free on this issue. In some states it is possible to mess this up by titling property as joint tenants (with or without right of survivorship), a mistake married couples in community property states make all of the time. In some community property states the property might still be characterized as community property for divorce and estate planning purposes and even capital gains tax purposes, but in others that form of ownership destroys the double step-up in basis. If you have a situation like this, call us to discuss how you can remedy it.
If you have moved from a community property state to a common law state, you will probably want to take steps to ensure that your community property retains its character. There are measures you can take to help with this. Call us if this is a concern for you.
If you are in a common law state and wish you could convert most or all of your property to community property, there is hope! In Tennessee, for example, you can create a joint trust and make a community property election. In other states it might be more complicated than that, which also means more expensive, but when tens thousands or even hundreds of thousands of dollars of potential capital gains are at stake, the cost of planning usually more than pays for itself.