Some Background
If you live in a community property state with your spouse, or if you had lived in a community property state with your spouse for any prior period of time, the assets accumulated while there have special rules that may have important impact on your planning.
Example: Husband and wife were married in a community property state and lived there for a few years. During that time, they invested in a hot tech stock. A few years later they moved to a non-community property state and lived in that non-community property state for 30 years and then finally engaged an estate planner to help them. They need to inform the estate planner that although they have lived for many decades in the non-community property state they had lived for a short while in a community property state and while there made a small investment in a stock that is now incredibly valuable.
The above example clarifies an important point that many people misunderstand. Merely moving to a new non-community property state alone has no impact on the characterization of assets acquired in a community property state as still being community property. The above example also illustrates how easy it is to overlook an important assets that may still have community property characterization.
There are nine states that have community property rules: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. But Alaska, Tennessee, South Dakota and perhaps other states have special rules that might provide similar or the same results as community property states. For example, you might be able to create a special community property trust in one of these states and thereby obtain the same treatment as if that property were community property.
Example: Husband and Wife live in New York which is not a community property state. They own interests in a family business that is very valuable and has little to no income tax basis. They create a special community property trust in Alaska and gift the business to that trust. That business interest will not be deemed community property. That might have a significant income tax benefit as explained below.
The concept underlying community property rules is that each spouse to the marriage should have equal rights to ownership of property that the couple acquired during the marriage or that either of them earned during the marriage. When either spouse dies, generally, the survivor will be entitled to 50% of those assets. If you inherit assets, or owned assets before the marriage, or received gifts during the marriage, those assets may be excluded from community property treatment, but you can choose to have the community property rules apply to those assets (if you live in one of the nine community property states or take advantage of one of the states that has special rules permitting you to obtain community property treatment).
Example: You were married in Arizona which is a community property state. That means that property you acquired during your marriage is presumptively considered to be community property and is treated as if owned equally by both of you as spouses. The characterization of property as community or separate is important in the context of marital dissolution and with respect to property distribution upon death.
For those not living in community property states the community property concepts may seem a bit surprising and not intuitive.
Example: Husband and wife live in a community property state. Wife purchased an asset and for the decades thereafter, including after the years they lived in a non-community property state, the asset remains listed just in wife’s name. Since the asset was acquired while you lived in a community property state as a married couple, it may have no relevance that the assets was always listed as solely owned by the wife, it may still be classified as community property and therefore be deemed owned 50% by husband as well. The fact that the title or ownership of the property may not provide a clue as to its characterization can make the identification process tricky.
Basis Step-Up On Community Property
A potentially significant income tax benefit from community property assets is that when the first of the couple dies the surviving spouse should receive an adjustment to the income tax basis the entire community property asset.
Example: Husband and Wife live in a community property state and own a rental property that is worth $1 million that they purchased jointly for $200,000 and fully depreciated. The income tax basis in that property is now zero. Husband dies. The entire interest in that rental property is stepped up to $1 million and if wife sells the property the next day there should be no capital gains to report and no tax to pay.
Example: Husband and Wife live in a non-community property state and own a rental property that is worth $1 million that they purchased jointly for $200,000 and fully depreciated. The income tax basis in that property is now zero. Husband dies. Only one-half of the interest in that rental property is stepped up to $500,000 and if wife sells the property the next day there should be a $500,000 capital gain on the non-stepped-up half on which she will have tax to pay.
First Step
As is clear from the above discussion, the first step in determining the impact of community property on your estate and asset protection planning is identifying which, if any, assets are properly characterized as community property. If you’ve lived your entire post-marriage life in a community property state that determination might seem easy. If you’ve moved in and out of different states some of which were community property states and others not, the analysis could be quite complicated. But even if you lived entirely in a community property state, the characterization of pre-marital assets, gifts received and inheritances may complicate the analysis.
You should provide complete information, and any supporting documents, to your estate planning attorney. Copies of marital records, income tax returns confirming the dates of moving to a new state (or bills from movers), records of when assets were purchased and for how much, may all be relevant.
What Community Property Characterization Means to Estate Planning
A first and obvious implication to estate planning is that if you have an asset that is characterized as community property you want to be certain that before you change the title or ownership of that asset (which may require a special step discussed below), that you are deliberate in the decision. Recharacterizing a community property assets into non-community property will eliminate the ability to get the full step up in income tax basis in that assets on the death of either spouse (i.e., on the death of the first spouse to die).
Example: Husband and wife own the highly appreciated stock discussed in the above example. They move to a new non-community property state and have their attorney change the character of that stock ownership from community property to one-half owned by each. That is referred to as “transmuting” the property and may be accomplished by a transmutation agreement. Husband dies. Only one-half of the value of the stock now gets a basis step-up. If there was no other significant planning goal that justified changing the characterization of the property, then perhaps the couple might have been better off by not doing so.
Leaving assets owned as community property may expose that assets to creditor reach that might not otherwise occur.
We Want to Make Gifts to Trusts to Use Temporary Exemption
Apart from all the general planning reasons to ascertain the characterization of assets as community property or not, the fact that the estate (gift and GST) exemption (the amount you can pass free of tax) will be cut in half in 2026, has many taxpayers evaluating making gifts before then (i.e., before the end of 2025) to use the current doubled (some call it bonus exemption or temporary exemption) before it disappears. For many couples that live in, or accumulated assets while in, a community property state, the nature of those assets may have to be changed before that can be done.
Example: Husband and wife started a family business while married living in a community property estate. That one business asset is now wroth $40 million dollars. Husband and wife have never made taxable gifts before and they each want to use up all of their current gift (and GST) exemption amounts of $12,920,000 (2023 amount, but it is inflation adjusted) each to lock it in before 2026. If they make these gifts before the exemption is reduced they will have preserved the entirety of the exemption. In contrast, contrast if they only gifted ½ of the exemption amount, when it is cut in half in 2026 they will have no exemption remaining and will have effectively lost half of the current exemption.
What Preliminary Steps Might Be Advisable Before a Gift is Made?
If the entity interests discussed above are in fact characterized as community property, then the community property business interest could not be transferred by either spouse as neither owns their interest independently. Instead, the first step in the estate plan may have to be for their attorney in the community property state to transmute the business interests from community property into a separate asset owned one-half by each of the husband and wife. That might require the use of a transmutation agreement. But also, if the business is a corporation the stock interests may have to be updated in the corporate books and records to reflect that each of husband and wife own separate interests, new stock certificates may have to be issued, etc. If the entity were a limited liability company there may be assignments from the couple as community property owners to each as a one-half owner individually and the operating agreement (the legal document governing the management and ownership of an LLC) may be amended and restated to reflect their signing in their new capacities.
Are There Step-Transaction Considerations that Might Affect Your Planning?
Let’s say the above couple had their community property state attorney properly transmute the family business interest into separate property so that each of husband and wife can make gifts of enough stock to use up their entire exemption amount. Assume all the ancillary documentation that their various lawyers recommend is also completed. Is that enough for their plan to succeed? Perhaps. Some tax advisers might suggest that if the gifts the couple contemplates are to spousal lifetime access trusts (“SLATs”) that more caution might be in order. SLATs are a trust in which one spouse creates a trust for the benefit of the other spouse, and perhaps descendants and others, and makes transfers to it. The beneficiary spouse can then benefit from those assets in the SLAT created by the first spouse. But consider that the value of the business investment could potentially be viewed as each of husband and wife owning an undivided half interest in the property when it was community property. Thus, is it possible that the IRS (or a creditor) might argue that the gift of stock husband made to a trust for the wife, that the wife may have had some ownership interest in that same stock until it was transmitted? If that argument is possible, then perhaps more time should be allowed to pass from the transmutation of that stock until either spouse makes a gift to a trust for the other. Otherwise, the IRS (or a creditor) might try to argue that each spouse had an interest in the assets given to the trust of which they are a beneficiary. If the IRS successfully collapsed that plan with an argument that wife was a donor of that asset to the trust she was also a beneficiary of the plan might fail. Perhaps time could be allowed to pass from the transmutation agreement to the date of the gift. How much time must pass to obviate this type of challenge is not clear. But the possibility of this issue is certainly worth discussing with your tax advisers when planning. Do note that some advisers do not see the above as an issue. As with so many complex estate tax planning concepts there is a wide disparity of views among different advisers.
Another Caution to Consider with Estate Planning with Community Property
There is another aspect to potential community property characterization of the equity interests in the company that should be considered. Assume that the value of the interest is $40 million and it is deemed to be entirely community property. For Husband to make a gift of $12,920,000 to use his exemption amount they would have to first “transmute” the interest into separate property. Let’s say the couple opted to transmute the entire business interest worth $40 million. That would result in $20 million being owned by each of Wife and Husband. Assume that Husband then gave $12,920,000 of his interest into a trust to benefit Wife and other heirs. Assume wife did not make such a gift at the present time. If the couple later divorces after the transmutation and husband’s gift transfer then Wife would have $20 million of separate property in which husband may have no claim. Wife would also be a beneficiary of a trust holding $12,920,000 of business interests. The husband would only have $7,080,000 of stock left in his name. Contrast this status to the status before the plan when each spouse has a one-half interest in the $40 million business. Husband’s position has been substantially worsened as contrasted to the prior situation. Couples need to consider all of this before undertaking an estate plan that might have significant adverse and unbalanced impact on each spouse.
Read the full article here