Helping Clients Plan for Community Property in a Separate Property State
If you are an estate planner, chances are you practice in a separate property (or common law) state. After all, there are only nine community property states. But that does not mean that community property will not appear on your radar.
Make sure to understand the difference between community property and separate property, so you can advise clients who bring the unique aspects of community property to your table.
Community Property States
The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Some other states, such as Alaska, South Dakota, Tennessee, Kentucky, and Florida, allow resident (and sometimes even nonresident) spouses to opt in to a community property system. A married couple may elect to treat some or all of their assets as community property by transferring them to a community property trust to therefore enjoy some of the tax and other advantages of community property.
Community Property vs. Separate Property
In a community property state, spouses who acquire property during their marriage own it equally and divide it equally if they get divorced. This is true regardless of whose names are on the title or deed. When one spouse dies, that spouse’s share of the community property goes to the surviving spouse unless directed otherwise by a valid will.
Separate property can be brought into the marriage or acquired during the marriage by an inheritance or gift. A spouse can sell, transfer, or devise separate property without the consent of the spouse who does not own the property.
Separate property can also be commingled with community property. For example, one spouse can inherit money from a parent and place it into the couple’s joint bank account. There is also quasi-community property, such as when a couple who lives in a community property state acquires land that is located in a separate property state.
The most important difference for tax purposes is that community property receives a full step up in basis when one spouse passes away. Separate property differs in that only the deceased spouse’s share of the property receives the step up in basis.
People change residences now more than ever, whether they are retiring, starting a new job, or moving closer to family. This means that a couple could live in a separate property state now, but may have called a community property state home in the past. For that reason, estate planners in separate property states should be prepared to deal with community property.
If you practice in a separate property state, here are four ways to help clients who own community property.
Keep Excellent Records of Property Transactions
The best advice to give a couple that has moved to a separate property state is to keep detailed records of their property transactions. The couple’s location when they acquired the property has important tax ramifications.
Clients should maintain the community property status of property originally categorized as community property until a comprehensive funding, ownership, and estate plan is in place. This is very important in three instances:
- The spouses are reluctant to liquidate the property due to capital gains tax exposure
- The property is highly appreciated
- One spouse will likely sell real estate or other interests when the other spouse dies
Determine Whether to Preserve Community Property Status
With community property status preserved at least temporarily, you can eventually determine whether to maintain this status. Community property status carries income tax and other benefits, but it also has some non-tax drawbacks.
Changing the nature of property from community to separate may be desirable for a few reasons, including the following:
- Protecting assets from liability related to one spouse’s career
- Maintaining financial autonomy
- Controlling the dispositions of certain assets at death
An estate planner should get to know a couple’s unique circumstances and goals to make an informed decision on whether to preserve the status of community property.
Carefully Consider Whether to Use a Joint or Individual Revocable Trust
Another important decision is whether a married couple should create a joint revocable trust or individual revocable trusts. A couple can transfer all of their separate and joint property into a joint revocable trust. In community property states, traditional couples (i.e., couples who are in their first marriage, only have children together, and have been married for a long time) tend to use a joint revocable trust to preserve the tax benefits of their community property.
When individual revocable trusts are created, the couple’s separate property is placed into their respective trusts. The couple’s jointly owned property is divided into shares, which are placed into their trusts.
Individual trusts may be a smart option for couples in the following situations:
- They want asset protection from one spouse’s creditors or professional liability
- They have had at least one other marriage or have a blended family
- They have more separate property than community property
- They have different trustee succession preferences
- They have different remainder beneficiaries
- They have complex estate and generation-skipping transfer tax planning needs
Some estate planners are reluctant to use joint trusts for couples with taxable estates due to the belief that they create uncertainty when determining the gross estate of the first deceased spouse. This could be the result of commingling of assets or poor record-keeping.
Prepare the Appropriate Property Agreements
Property agreements, marital agreements, and transmutation agreements can be useful when a spouse has separate property that they want to protect from the other spouse’s creditors or a divorce. These agreements are also helpful when the spouses want to change the nature of the property from community to separate (or vice versa) for tax or other purposes. In addition, these agreements can be used in blended families or other situations in which the spouses’ beneficiaries who will inherit upon death are different.
One more piece of advice to give clients is to avoid commingling community property with separate property after the estate plan is in place. This holds true whether the acquired property is separate, community, or a combination of the two.
With all of this knowledge at your fingertips, you can make your clients’ lives easier by providing them with expert planning for their community and separate property.