Community Property Tax Advantages and Pitfalls for Ill-Equipped Attorneys

Community Property, a marital property regime primarily adopted in the western states as a result of Mexican and Spanish law influences, has been the cause of confusion and disputes in divorce and probate proceedings but also may present a substantial tax advantage in certain circumstances. In this overview, we will take a look at both, as well as the dangers of using an estate planning attorney unfamiliar with the laws of community property states and the impact on titling such property incorrectly.

In general, the principle of community property is that during marriage, all earnings of the spouses, and the property acquired from those earnings, are community property unless both spouses agree to separate ownership. Property that is not community property is the separate property of one spouse or the other or, in the case of a tenancy in common or joint tenancy, both. Separate property includes property acquired before marriage and property acquired during marriage by gift or inheritance. In Idaho, Louisiana, Texas and Wisconsin, income from separate property is community property. In other community property states, income from separate property retains its separate character. As one might guess, maintaining this characterization can be challenging and spouses who desire to do so ought to be careful with commingling of separate property income and community property income. Advising attorneys also need to keep this top of mind to avoid future disputes. In circumstances in which the characterization of property is doubtful, there is a strong presumption in favor of community property.

It should be noted that community property states differ on the characterization of personal injury recoveries and professional degrees. If the property has been commingled, or acquired from both separate and community funds, tracing determines the portion of the property that is community. With little evidence, the presumption in favor of community property again applies. Life insurance is especially tricky.

To avoid tracing problems, a couple can enter into an agreement that will control the character of their property. They may change separate property into community property, or they may change community property into a joint tenancy, a tenancy in common, or sole ownership of one spouse. Couples sometimes agree that all their property is held as community property to achieve the favorable income tax treatment given community property. Upon the death of one spouse, under IRC § 1014, the entire value of the community property receives a stepped-up basis for determining capital gains when the property is eventually sold. Any appreciation in value between the acquisition and the date of the first spouse’s death is never taxed as capital gain.

Whereas community property interests receive this benefit, in the instance of separate property, only the decedent’s one-half interest in the property receives a stepped-up basis. One can see the substantial advantage in entering into an agreement to title all property as community property for this reason. That being said, spouses on shaky ground may not be so keen on titling separate property as community property to take advantage of a capital gain tax benefit when the first spouse dies when the marriage may be dissolved well before that occurs and the spouses would each have a one-half interest in each portion of community property.

Moving from a separate property state to a community property state may cause problems. Under traditional law, the law of the state where the couple is domiciled when movable property is acquired determines the ownership of the property. In a separate property state, a wage earner husband’s wife is protected by her elective share, but if they move to a community property state, the property remains the husband’s separate property, but as a result of the move, the wife loses the protection of the elective share.

Another issue that arises in community property states and with spouses who reside there is when spouses move from community property to separate property states. Generally, such a move does not change the preexisting property rights of the spouses unless the spouses agree to convert it to separate property. The Uniform Disposition of Community Property Rights at Death Act, enacted in 16 separate property states, provides that community property retains its status upon such a move, unless the spouses agree otherwise. But in a state that has not adopted the Act, a court might automatically convert community property into a form of common law joint ownership.

Spouses who are contemplating such a move may want to seek the advice of a qualified estate planning attorney familiar with the nuances of community property to create a revocable trust stating all property within the trust is community property. Some lawyers in separate property states lack the understanding of the community property system and may recommend that spouses title to joint tenancy. However, if this is done with the intent of changing community property into a common-law interest, the advantageous step-up in capital gains tax basis advantage of community property is lost, and the attorney could be liable for malpractice.

Estate planning for spouses who have ever lived in, or owned property in, a community property state should be carefully thought out for the best tax advantages while maintaining within the desired characterization of the spouses’ interests. These issues discussed above are only are the tip of the iceberg when looking at community property situations. If you or your attorney feel you need assistance in this area, please feel free to schedule a consult with the Hood Law Group.

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*This post was originally published on June 2, 2015