What’s the impact of a community property system?

There are 10 states that have community property systems: Alaska (elective), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Under a community property system, your total estate consists of your 50% share of community property and 100% of your separate property. What’s the difference?

Community property usually includes assets you and your spouse acquire under two conditions: 1) during your marriage, and 2) while domiciled in a community property state. Each spouse is deemed to own a one-half interest in the community property, regardless of who acquired it. For example, wages and other forms of earned income are treated as community property, even though earned by only one spouse.

Separate property usually includes property you and your spouse owned separately before marriage and property you each acquire during marriage as a gift or inheritance that you keep separate. In some states, income from separate property may be considered community property.

In most community property states, spouses may enter into agreements between themselves to convert separate property into community property or vice versa. This can be an important part of your estate plan.

Remember, marital rights are expanded

Community property states start out with greater protection for the surviving spouse because he or she is deemed to own 50% of any community property interest. But some states go much further, and the laws can be complex. For example, rules may vary depending on how many children you have and how much the surviving spouse owns in relation to the deceased spouse.

In some cases, the surviving spouse is entitled to full ownership of property. In other situations, he or she is entitled to the income or enjoyment from the property for a set period of time. Seek professional advice in your state, especially if your goal is to limit your surviving spouse’s access to your assets.

Plan carefully when using a living trust

If a living trust isn’t carefully drafted, the property may lose its community property character, resulting in adverse income, gift and estate tax consequences. For example, improper language can create an unintended gift from one spouse to the other. To avoid any problems, the living trust should state that:

Property in the trust and withdrawn from it retains its character as community property,
You and your spouse each retain a right to amend, alter or revoke the trust, and
After the death of one spouse, the surviving spouse retains control of his or her community interest.

Reap the basis benefit

Community property owners receive a double step-up in basis benefit. Say you and your spouse hold $200,000 of stock as community property. Only one-half of the stock ($100,000) would be included in the estate of the first spouse to die. But, the income tax basis of all of the stock would rise.

Therefore, the surviving spouse could sell his or her 50% share of the stock at no gain, as well as the deceased spouse’s 50% share.

Watch out for unwanted tax consequences with ILITs

Several community property state issues must be taken into account to avoid unwanted tax consequences when an ILIT owns a life insurance policy. These typically relate to who owns the policy before it’s transferred to the trust and whether the future premiums are gifted out of community property or separate property.

For example, if you give an existing policy that was community property to an ILIT and the uninsured spouse is a beneficiary of the trust, the estate of the surviving uninsured spouse could be taxed on 50% or more of the trust. However, proper titling of the policy, effective gift agreements between spouses and proper payment of premiums can avoid this problem. Be sure to get professional advice on these arrangements.

Distinguish between separate and community property for FLPs

For community property state residents, it’s important to state in the FLP agreement whether the FLP interest is separate or community property. In addition, you should consult your attorney to determine if a partner’s income from an FLP is community or separate property.

Get spousal consent before making charitable gifts

Under the community property laws in many states, a valid charitable contribution of community property can’t be made to a charity by one spouse without the consent of the other spouse. Consent should be obtained before the close of the tax year for which the tax deduction will be claimed.

Enjoy easier generation-skipping transfers

Community property can be the perfect vehicle for GSTs because a married couple with community property equal to their combined GST tax exemption amount can qualify for effective use of this strategy without needing to transfer any assets to each other.

Weigh your property treatment options

You don’t always have to follow the property system of your state of domicile or the state in which you buy real estate. For example, if you live in a community property state and want to avoid having to obtain your spouse’s consent to sell or make gifts of community property, you may elect out of community property treatment. But you also can retain community property treatment if you move from a community property state to a separate property state.

To do this, consider establishing a joint trust to hold the community property when you move to the new state or simply prepare an agreement outlining the status of the assets as community property. But you must ensure the community property assets remain segregated. If they become intermingled with separate property assets, you could lose the community property status.

Another option is to leave assets in a custody account governed by the laws of the community property state. It may be possible to retain the community property nature of the assets by simply segregating them from other assets on arriving in the new state. But make sure your estate planning documents that dispose of the segregated assets call for the disposition of only one-half of the assets at the death of each spouse.

You can execute similar strategies if you have separate property that you wish to remain separate when you move to a community property state. Again, to retain its separate property status, the property can’t become intermingled with community property. So, make a well-thought-out decision about how you’d like your property to be treated.

If you aren’t concerned about the limits on community property and are interested in obtaining its tax advantages but don’t reside in a community property state, consider taking advantage of the Alaskan system, which allows nonresidents to convert separate property to community property. Note that implementing such a decision is complex, involves placing property in trust, and requires careful planning and coordination with your advisor.