Community Property vs. Separate Property from an Estate Planner’s Perspective

Anyone who has ever watched a courtroom drama tv series has heard the phrase "California is a community property state!" Maybe that's an over-generalization on my part from watching the entire Drop Dead Diva series while attending law school. In fact, there are nine community property states--Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. So perhaps the above-quoted phrase used any one of these states. In any case, it was brought up over and over and over again.  What difference does it make if a state is a community property state?  While the significance of a community property jurisdiction is typically discussed in terms of divorce proceedings, it also plays an important role in estate planning. It can mean a big difference in how much money you or your spouse pays to the federal government after one of you dies.

Joint property owners in community property states enjoy a tax benefit of a 100% stepped up basis upon the first spouse’s death. When one spouse passes away, it is as if that spouse owned the entire property and gifted 100% of it to the surviving spouse at death. As a result, the surviving spouse takes a fair market value tax basis in the property at that time, regardless of how much the property had appreciated in value between the time it was acquired until the time of the first spouse’s death.  This increase in the tax basis of a jointly held asset is called a “stepped up” basis. In separate property states, however, the deceased spouse is deemed to only own half of the jointly held property, which is then gifted to the surviving spouse at death.

To illustrate, we’ll use hypothetical stocks, although this principle applies to any asset with significant appreciated value, such as farm land or other forms of real property or securities. Alan and Bernice, a married couple who live in a community property state, purchase 100 shares of Orange Corp., a computer technology company, in 2001 for $10/share, which serves as their tax basis (total tax basis of $1,000). At the same time, Chris and Diana, a married couple living in a separate property state, purchase the same number of shares of Orange Corp., giving them the same tax basis. Each couple owns the property jointly as spouses.

Alan and Chris both die in 2018, at which time the stock is valued at $200/share.  In other words, each couple’s stocks are worth a total of $20,000. Alan, in the community property state, is deemed to gift 100% of the jointly-held asset to his spouse, Bernice, upon Alan’s death.  Because Alan is deemed to have held the entire asset at death, it receives a 100% step up in basis.  So Alan effectively gives Bernice $20,000 of Orange Corp. stock, and Bernice’s stepped up tax basis in the stock is $20,000.  If Alan and Bernice were to sell the stock just before Alan died, they would have taxable income of $19,000.  If Bernice sold the stock shortly after Alan’s death for the full $20,000 value, she would have no taxable income thanks to the stepped up basis.

Chris, however, in a separate property state, is deemed to only gift half of the stock to Diana.  Therefore, Diana only gets a stepped up basis on Chris’s half, but not her own. So Chris’s 50 shares, at $200/share gets a stepped up basis of $10,000, while Diana’s half keeps its basis of $500.  If Chris and Diana were to sell the stock just before Chris died, they would have taxable income of $19,000.  If Diana sold the stock shortly after Chris’s death for the full $20,000 value, she would still have $9,500 of taxable income.

This disparity between community property states and separate property states caused lawmakers in South Dakota, Alaska, and Tennessee (all separate property states) to provide a way for married couples in separate property states to enjoy this tax benefit. This is possible through a community property trust (or, in South Dakota, a “Special Spousal Property Trust”). These revocable trusts allow married grantors in separate property states to maintain full control over the asset while still enjoying the tax benefit as though they lived in a community property state.

For more information on community property trusts and an explanation of related terminology, check out this blog post from last year. For information in how to integrate this type of trust in your estate plan, review this June 2017 post. In 2016, South Dakota became the third state to offer this type of trust. If you and your spouse own assets with significant appreciation in value, contact a South Dakota estate planning attorney today to explore how this tax planning tool can help you save money down the road.