Community property laws are, in short, a mixed bag: sometimes a boon and sometimes a nightmare.
Many married couples living in the U.S. own assets that are deemed legally separate. This may include a business or real property purchased in one person’s name alone. The reason for this designation is that the laws of most states treat married individuals as financially unrelated to their spouse, except for joint accounts and those assets specifically mentioned in a will. However, there are some states called community property states that have different laws on this issue.
As a result, it’s important to know about community property laws in the event you move to one of these jurisdictions or already live in one.
Barron’s article, "How Community Property States Are Different," explains that Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin are the states in which everything you acquire during a marriage is considered legally owned by both spouses. For example, their state statutes view a couple as the co-owners of a business with a 50-50 partnership.
Here are a few other issues to consider:
Premarital assets. Typically, any wealth acquired before the marriage and any inheritances acquired at any time by one spouse are not the property of the other spouse. If you intend to keep them separate, leave them out of your community accounts created after the marriage. If you want to join finances, an estate planning attorney can help you with pre- and post-marital agreements and community property agreements to pool assets.
Estate plans. In most states, a married couple’s assets are divided evenly in life, and the same is true when one dies. One half the couple’s assets become part of the estate, which can make for major taxes in some situations. If a couple buys a home for $1 million, which then appreciates to $5 million, half of the value of the home—or $2.5 million—becomes a part of the decedent spouse’s estate. It’s given a step-up in basis—a readjustment of the value of the home to the market price over what was initially paid. But the surviving spouse keeps the original cost basis of $500,000. If that spouse wanted to sell the property upon the death of the spouse, he or she would have a cost basis of $3 million (the $500,000 cost basis plus the adjusted basis of $2.5 million) amounting to a $2 million capital gain.
Community property states are a plus in this case because they give a step-up in basis to the entire home. In this example, the surviving spouse will also get a step-up in basis, which means if he or she sells the home, there would be no capital gains tax owed. However, the step-up in basis can complicate wealth transfer planning.
Gifting. In community property states, both spouses have to agree on gifts from joint funds. No one can make a gift of your property without your consent, and without that consent, the spouse who didn’t make the gift can revoke the gift at a later date. It’s best to make sure it’s in writing—even when it’s a gift to each other.
Life insurance. Talk with an experienced estate planning attorney before you create an irrevocable life insurance trust. For example, a husband creates an irrevocable life insurance trust to benefit his wife, and the trust buys a $10 million life insurance policy on his life. He will need to be certain that any gifts made to the trust and used to pay the premiums are paid for from a non-community property account—payments cannot come from a joint account. Otherwise, it places a portion of the trust into the estate of his wife, which defeats the purpose of having an irrevocable life insurance trust in the first place and subjects it to an estate tax. Sign a transmutation agreement, which makes the gifts to the trusts entirely one person’s.
It’s important to remember that when community property laws are advantageous to your situation, you can carry community property over with you when you move to a new state. An agreement can preserve the community property state of already-acquired assets and conserve joint trusts to save them from getting comingled with assets in the new state.
Reference: Barron’s (June 28, 2016) "How Community Property States Are Different"
If you're moving to a state where community property law is an issue, be sure to consult with a qualified estate planning attorney who understands community property law. Give us a call at (978) 342-1914 or visit us at www.dellamonaca.com.