For couples in certain states, the concept of "community property" plays a significant role in how assets are owned and managed during marriage and how they're divided in the event of divorce or death. Unlike common law property states, which generally recognize individual ownership based on title or acquisition, community property states operate under a system of shared ownership. This article explores the key aspects of community property, its implications, and where it applies.
What is Community Property?
At its core, community property means that most assets acquired during a marriage are considered equally owned by both spouses. This applies regardless of whose name is on the title, whose income was used to purchase the asset, or who primarily uses it. The underlying principle is that marriage is an economic partnership, and both partners contribute to the accumulation of wealth, even if one spouse is the primary earner or manages the household.
Key Features of Community Property:
· Equal Ownership: Each spouse owns a 50% share of all community property. This means that decisions regarding these assets often require mutual consent.
· Acquisition During Marriage: The crucial factor is when the property was acquired. Assets obtained during the marriage are generally considered community property.
· Separate Property: Property owned before the marriage, or received as a gift or inheritance during the marriage, is generally considered "separate property" and belongs solely to the individual who acquired it. This property is typically not subject to community property rules.
· Division Upon Divorce: In a divorce proceeding, community property is typically divided equally between the spouses. This can involve selling assets and splitting the proceeds, or allocating specific assets to each spouse to achieve an equal division.
· Inheritance: In the event of a spouse's death, their half of the community property generally passes to their heirs, which may be the surviving spouse or other beneficiaries named in a will.
Examples of Community and Separate Property:
· Community Property: Income earned during the marriage, a house purchased during the marriage, a car bought with marital funds, stocks acquired during the marriage.
· Separate Property: A house owned before the marriage, an inheritance received during the marriage, a gift given specifically to one spouse.
Special Community Property Tax Issues:
· Married Filing Separately: If a spouse earns W-2 income during marriage, the wages may be considered as earned by ½ for each spouse.
· Estate Tax – Full Basis Step-Up: In community property states, when a spouse passes away, the surviving spouse will receive a 100% step-up in the cost basis of the assets. Conversely, in non-community property states, when a spouse passes away, the surviving partner will only receive a 50% step-up in the cost basis of the assets. This means that a basis step-up in community property states can reduce the potential capital gains on an asset if it is later sold, and allow the surviving spouse to liquidate assets with minimal income tax consequences.
· LLCs & Partnerships: In non-community property states, a husband and wife owning an LLC will typically cause the LLC to be taxed as a partnership, which brings additional complexity and tax reporting costs. In community property states, a husband and wife has the option of filing an LLC that they solely own between the two of them (in whatever proportions), as either a disregarded entity or as a tax partnership. This tax flexibility is a nice benefit!
Community Property States:
The following states adhere to community property laws:
· Arizona
· California
· Idaho
· Louisiana
· Nevada
· New Mexico
· Texas
· Washington
· Wisconsin
Optional Community Property States:
The following states allow for certain special spousal trusts that may allow selective property to be taxed as community property:
· Alaska
· Florida
· Kentucky
· South Dakota
· Tennessee
These trusts are typically used if a married couple has a long and stable relationship, own significantly appreciated assets, and a full basis step-up on the first-to-die is valuable. For example, if a family owns a $10 mil. ranch with a $1 mil. cost basis, a community property trust could allow a surviving spouse to sell the ranch in its entirety without paying capital gains tax. Without such trust, and if the ranch was held jointly, there would be a $4.5 mil. capital gain on such a sale (after a 50% basis step-up).
Important Considerations:
· Commingling: Mixing separate property with community property can complicate matters. For example, if separate funds are used to make a down payment on a house purchased during the marriage, the portion of the house purchased with separate funds may remain separate property, while the rest is community property. As a general matter, separate property should be maintained separately to avoid conversion into community property.
· Prenuptial Agreements: Couples can enter into prenuptial agreements to modify the application of community property laws. These agreements can specify which assets will be considered separate property even if acquired during the marriage.
· Debt: In community property states, debts incurred during the marriage are generally considered community debts, meaning both spouses are responsible for them.
Conclusion:
Understanding community property is crucial for couples residing in these states. These rules impact financial planning, asset management, and the division of property in case of
divorce or death. Please consult with your attorney regarding any questions regarding the applicability of community property rules to your case. This article is intended to provide general information, and is not a substitute for consulting with qualified legal counsel. Once determination of community property is made, we advise readers to consult their tax advisor for specifics on how the community property rules will influence income and estate taxes.