ESTATE PLANNING FOR MARRIED COUPLES – SEPARATE PROPERTY VS. 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.

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.

Community property ownership also provides another estate tax planning advantage over separate property. Unless specifically provided for, a community property spouse has no survivorship rights, other than a homestead. The deceased spouse’s half of the property may be transferred to a tax-sheltered Family Trust without the risk that the transfer will be defeated by an automatic transfer to the surviving spouse. This is contrary to a separate property system where if a couple owns property in both names, the surviving spouse automatically owns all such property. The unfortunate result is that no property remains to be transferred to a tax-sheltered Family Trust. Couples intending to reduce estate taxes in separate property states must carefully weigh the estate tax consequences of joint tenancy ownership of property.

A final benefit of owning property in a community property state is that individuals living there can choose for themselves which property system they desire for part or all of their property. They can classify their property as community, separate, or a mix of the two depending on their individual circumstances and desires. These options may best be handled by creating a Community Property Agreement when permitted under state law.

A Community Property Agreement is a contract that a married couple in a community property state sign as a couple that specifies how they want their property to be classified. Classification may be as community property or separate property, or a mix of the two. It is very important that couples in community property states take advantage of the opportunity to prepare a Community Property Agreement. Otherwise due to the complexity of the law, it can be very difficult to know exactly how your property is classified, and unless you know how it is classified you cannot know with certainty how it will pass at your death.

As stated in Chapter One, the fundamental principal in estate planning is that a person may only transfer what he or she owns. In a community property state, a married person owns only one-half of the community property and all of his or her individual property. Distinguishing community property from individual property can be a rather complex exercise.

Community property states use a complicated formula used to determine how much of a mixed property account balance is community and how much is individual. This formula is applied at the first spouse’s death to determine how much of the mixed property account belongs to the surviving spouse as community property. This calculation is critical for estate planning purposes because the deceased spouse is legally entitled to pass on only his or her own property to beneficiaries other than the surviving spouse.

The complexity of these issues frequently cause Community Property Agreements to be used to classify in advance all of the couple’s property as individual or community in order to simplify the process at the first spouse’s death and save costs. There are pros and cons to classifying property as individual or community and deciding which classification is best often entails an asset-by-asset inquiry by an experienced estate planning attorney.

One advantage of classifying your property as community is that it will receive the beneficial double step-up in its tax basis at the first spouse’s death, but there are other factors to consider. In some cases, a couple may want to forgo the capital gains tax benefits of community property and instead classify property as individual to accomplish other estate planning goals. Such possible goals could include the following:

• They wish to provide for children of a prior marriage;
• One spouse has a large family inheritance; or
• One spouse has exposure to creditor claims and wishes to protect the other spouse from such claims.

In summary, a sound estate plan for married couples must always take into account the specific laws of the state they live in. There are important estate planning decisions that must be made whether one lives in a separate property state, or in a community property state. Your estate planning attorney can assist you in explaining these complicated matters to help you maximize your estate planning opportunities and give you confidence that you know exactly how your estate will pass at your death.