Community property law

The notion of "community property" remains oddly foreign to most lawyers from states outside the few which recognize the Spanish/French concept. Actually, though, the idea is hardly foreign at all--it is consistent with the way I believe most married couples think of their assets. It is also consistent with what most states mandate upon divorce--the assets acquired during the marriage will usually be divided, and usually equally divided, in a divorce setting.

The Fleming & Curti, PLC, website has several articles discussing community property, including this week's (October 1, 2007) Elder Law Issues. In fact, there is an abundance of information over at the Fleming & Curti website.

So what's the big deal? Well, the community property states handle things differently in a number of ways. First, there is the issue of stepped-up income tax basis. In a nutshell, it works like this:

1. If you die owning property in your own name, your heirs (spouse or otherwise) receive it from your estate with an income tax basis set at its fair market value at the time of your death (there are lots of caveats, qualifiers and exceptions, but we're going to ignore those for now). That means that if your heirs sell the property shortly after your death, they will pay no (or very little) income tax on the sale. If they hold it for later sale, they will pay income taxes only on the appreciation in value between your death and that later sale.
2. If you die owning a piece of property in joint tenancy, generally speaking your joint tenant will receive your share with a stepped-up basis, but will retain their share with its original basis. That means that if, say, you and your brother buy a $100,000 parcel of land as joint tenants, and it is worth $250,000 on the day you die, your brother will pay capital gains taxes only on the $75,000 of gain realized on his 1/2 interest. The same principle is true if the joint tenant is your spouse.
3. If you die owning that same property as community property (which may, depending on your community-property state, also include a "with right of survivorship" qualifier), your spouse will receive a 100% step-up in the basis on your death--and vice versa. This may not make logical sense, but it gives a significant tax benefit to property held as community property. That's the good news. The bad news, of course, is that one of you must die before the survivor receives the benefit.

Community property rules are also responsible for another issue that mystifies many non-lawyers. Why do some estate planning attorneys prefer to create two separate trusts for a husband and wife, while others usually create a single joint trust? The division is mostly along community property / common law property lines; lawyers in community property states generally favor joint trusts, and common law state lawyers more often prefer to establish two separate trusts.

That can lead to unnecessary confusion; if your joint living trust was drafted in a community property state and you move to a common law property state, you may well be advised to create two trusts and separate your jointly-held assets. Conversely, your new lawyer in a community property state might well advise that you collapse your separate trusts into a single trust. Both types of advice may be based more on the lawyer's familiarity and comfort level than on any real legal difference.

Which states use the community property approach to assets acquired during the marriage? Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are the community property states, with the last two having come to the concept relatively recently. Alaska permits property in a trust to retain its community property character, but does not authorize creation of new community-property interests outside a trust.

Is all of this enough reason for you to sell everything you own and move to, say, New Mexico? Probably not. We tend to think that your personal happiness, health and well being are actually more important than the tax bite at your death. There are also other issues to consider, including state estate, income and property tax rates, state protections against creditors and other, less legal items. But if you are resolved to move to New Mexico (to continue the example), the somewhat favorable treatment of community property might well be the proverbial cake's icing.

Robert Fleming
Fleming & Curti, PLC
Tucson, Arizona