What are some of the legal consequences of owning property separately rather than as community property?
The way your property is classified is important because there are several estate planning advantages for married couples that own property in a community property state that do not exist for couples living in separate property states. The first involves a capital gains tax benefit.
Couples that own community property that has appreciated in value, and for which a capital gains tax would ordinarily be due when it is sold, receive what is known as a double step-up in its tax basis at the death of the first spouse. The benefit of this double step-up in basis becomes apparent when one calculates the capital gains taxes otherwise due as a result of the property’s appreciation. The double step-up in tax basis will quite often enable the surviving spouse to escape capital gains taxes entirely because the starting point in calculating the property’s appreciation is the date of the first spouse’s death—not the date the couple originally purchased the property. Assets sold immediately after the death of the first spouse will show no taxable appreciation.
A brief example shows how this works. Suppose a married couple in a separate property state jointly owned some stock they had purchased ten years ago for two dollars. The two dollars becomes the starting point, or tax “basis,” for calculating any taxable appreciation in the stock’s value. Let’s say that during those ten years the stock appreciated in value to twenty dollars. If the stock were sold while both spouses were living, a capital gains tax would be imposed on the eighteen dollars profit.
Now assume the husband of that couple died before the sale. If the jointly owned stock was sold after his death, the tax laws give a step-up in basis for the decedent husband’s half of the property, but no step-up for the surviving wife’s share. This means that if the stock were sold for twenty dollars the day after the husband died, there would be a step-up in basis from one dollar (the husband’s one-half of the original two-dollar basis) to ten dollars (his one-half of the twenty dollar sale price). But no step-up occurs on his surviving wife’s half interest. Accordingly, upon the sale she will be required to pay a capital gains tax on the nine dollars profit attributable to her half of the stock.
Compare this to the result that would occur if the couple lived in a community property state where they would own the stock together as community property. When the husband died, not only would his half of the property receive a step-up in basis but hers would be stepped up as well, even though she is still living. This is the meaning of the term double step-up in basis. Due to this double step-up in basis, the property’s tax basis becomes its fair market value on the date of the husband’s death. If the property’s basis is twenty dollars when the husband dies, and the wife thereafter sells it for twenty dollars, there is technically no profit on the twenty-dollar sale and thus no capital gains tax is owed. This can be a huge tax benefit for couples that own significant amounts of appreciated assets.