Community Property Trusts
In the context of estate planning, there are many practical reasons why one would need to sell an asset, which could result in a capital gain. For example, the death of a key person in a family business may necessitate a sale of the business due to the lack of participation and knowledge once provided by the decedent; this sale could result in a capital gain because of possible buy/sell agreements or the large overall value of the company. Market conditions may precipitate the sale of assets to hedge a market downturn or to diversify a portfolio. Or assets may need to be sold to replace lost earnings or minimize responsibilities for a surviving spouse.
Generally speaking, the “capital gain” is calculated as the difference between the initial purchase price and the later sale price. The amount of tax you have to pay for the capital gain depends on an individual’s tax brackets, available deductions and exclusions, and the structure of ownership for certain assets. However, there is a special rule for inherited property, known as the “step-up in basis” rule. Here’s how it works: David inherits a house from his uncle who bought the house in 1982 for $70,000. The home was worth $800,000 at the time of his uncle’s death. If David decides to sell the house, his basis will be $800,000, so he will only pay capital gains if the property is sold for more than $800,000. Absent the step-up in basis, David would have paid capital gains on $730,000.
For married couples, the application of the basis for a step-up depends on the jurisdiction of the property. A majority of jurisdictions in the U.S. — including South Carolina — are separate property states. This means that property acquired before or during the marriage remains separate, unless otherwise agreed upon. A married couple could have property owned jointly in a separate property jurisdiction (usually in the form of joint tenants with rights of survivorship in South Carolina). In this case, the surviving spouse would only receive a basis step-up on the decedent’s separate one-half interest. As an example, spouses purchase a home for $100,000. When the first spouse dies, the property is worth $200,000. The surviving spouse receives a half step-up, such that the new basis on the home is $150,000, and the survivor will pay capital gains if the property is sold for more than $150,000.
In contrast, many states are community property jurisdictions or allow for the application of community property rules. The concept of community property is that property acquired by either spouse during a marriage vests a one-half interest in the property to each spouse as jointly owned, or “community”, property. Under community property rules, the surviving spouse receives a double step-up in basis. For example, spouses purchase a home for $100,000. When the first spouse dies, the property is worth $200,000. The surviving spouse receives a full stepup, such that the new basis on the home is $200,000, and the survivor will not pay capital gains upon a sale, unless the house is sold at a later date for a price higher than the $200,000 basis. Assuming the asset is depreciable, not only does the step-up in basis eliminate or greatly reduce any capital gains tax liability, but it also allows the surviving spouse to generate additional depreciation deductions starting from the fair market value of the property as of the decedent’s date of death, thereby providing an additional offset of income from other sources.
Recognizing the income tax benefits of owning community property and the potential to generate revenues for the state, Alaska and Tennessee have enacted laws allowing both residents and non-residents alike to opt in to a community property regime. Although the state statutes are not identical, the requirements for creating a community property trusts are generally as follows:
• A declaration in the trust document that the trust is a community property trust;
• At least one qualified trustee (which means a resident of Alaska or Tennessee or a qualified bank or trust company located in Alaska or Tennessee);
• Signatures of both spouses; and
• Specific “warning” language in capital letters to be inserted at the beginning of the trust document.
Community property trusts work well in conjunction with well-crafted estate plans that have already been implemented. Assuming that a couple has already created separate or joint revocable trusts, appreciated property currently owned by the revocable trust or by the spouses individually would be transferred into a new community property trust. At the death of the first spouse, when the allowable basis adjustment occurs, the community property would be divided. One-half of the property would be distributed according to the deceased spouse’s estate plan, and the other one-half would be distributed to the surviving spouse either outright or into a structure consistent with the survivor’s estate plan.
Despite the tremendous income tax benefits, community property trusts do come with some inherent risks which must be weighed against the benefits. Community property assets — like joint tenancies — are subject to the creditors of either spouse. To reduce this risk, it is recommended that the property be held in an LLC for asset protection purposes. If there is a divorce, the trust will terminate and each spouse will each receive one-half of the community property; this equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust. Finally, each spouse must have certain rights in order to qualify for the marital deduction, thus avoiding a gift tax when the assets are moved in to the trust.
A community property trust is a powerful tool that can be leveraged to drastically reduce or eliminate capital gains, provided the conditions are right. The ideal clients for community property trusts are long-term married couples who are not residents of a community property state and one or both individuals own highly appreciated property, stocks, real estate or business interests; and/or their financial portfolio is heavily weighted in one or two stocks which they are reluctant to liquidate because of exposure to capital gains tax; and/or they have rental real estate the likely survivor does not want to manage and will liquidate after the death of the first spouse. The current state of the law has made the capital gains tax the new “estate tax” that should be on everyone’s radar.