Another distinct advantage of community property ownership is that it works well for couples that wish to reduce or eliminate estate taxes. To avoid such taxation, property is transferred at the death of the first spouse to a tax sheltered Family Trust (also referred to as a Credit Shelter Trust or Bypass Trust), rather than directly to the surviving spouse where it would be taxable in that spouse’s estate.
Community property works well for this type of estate tax planning because it tends to equalize the value of the estate owned by each spouse. In community property states like Wisconsin, even if only the husband’s name appears on the title, one half of it (with some exceptions) is still considered legally owned by the wife; therefore, regardless of which spouse dies first, there are assets to transfer to the tax-sheltered family trust.
A different situation occurs in a separate property state when couples have all of the property titled only in the name of the husband. The husband is viewed as the owner of that property not only for purposes of passing on the property at death, but also for the imposition of estate taxes. This situation can cause a major tax problem if the wife dies first. Since everything is legally titled in her husband’s name, there will be no property from the wife’s estate to transfer to the tax-sheltered Family Trust. The opportunity this couple had to reduce estate taxes is lost forever.
In separate property states, the problem of one spouse individually owing the bulk of their combined assets can be solved by gifting selected assets from the spouse with the larger estate to the spouse with the smaller estate. This swap of assets continues until both spouses own assets in the amount needed to fund the Family Trust regardless of who dies first. A downside to this strategy is that if appreciated assets are gifted to the spouse who ends up the survivor, there is no step-up in basis at the death of the first spouse and thus no capital gains tax savings