COMMUNITY vs SEPARATE PROPERTY

     In common law states, typically the surviving spouse may elect against the will of the predeceasing spouse and get what would be the intestate share. This is often around 1/3 of the “estate.” In some common-law states, the “estate” against which the survivor may elect is the augmented estate, including non-probate assets such as a revocable trust. In other states, the survivor may only elect against the probate estate.

     About one-half of the separate property states have “tenancy-by-the-entirety” or “TBE.” This form of ownership is akin to joint tenancy property, except it is limited to a married couple. Depending upon the state, TBE may be available only for real property or for both real and personal property (like an investment account). Also, the couple must act together in order to encumber or sell the property. As a result, TBE property offers cheap creditor protection, with limitations.

     First, if the creditor is a creditor of both spouses, like someone who slips on the front walk of the residence, the property can be reached. Second, if the spouse without creditor issues dies, then the property goes automatically to the spouse with creditor issues and is no longer in TBE. Finally, in the event of divorce, the TBE would be severed, typically into tenants-in-common property.

     Nine states have community property, all but one of them is west of the Mississippi River. They are Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Wisconsin, and our own state, Washington, This is another in the series of blogs on the basics of estate planning. In this blog, we’ll look at common differences between community property and separate property states.

     As stated above, nine states, including Washington, have community property, namely Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Wisconsin. In addition, Alaska allows you to elect into community property for property held in a community property trust. Other states may follow Alaska’s lead and legislation is pending elsewhere to do so.

     Community property varies somewhat from state to state. The general notion is that all fruits of labor of either spouse is the property of the spousal community and should be shared equally. In Washington, the presumption is that property acquired during marriage is community, unless there is proof the property was brought into the marriage, there is a contrary agreement, the property was a gift or inheritance, or the property was the separate property of one of the spouses prior to the move to the community property state.

     The character of the property is determined based on the domicile of the parties and the source of funds. The manner in which the property is titled is not dispositive. Often, this is a frustration to attorneys not accustomed to community property. Thus, if John is married and earns a paycheck and the paycheck goes into his bank account titled in his name alone, the funds are still community property. If he then takes the funds and buys another asset, that asset is also community property. In other words, there is tracing of the source of the funds. The tracing can be very difficult at times. But, there are presumptions that apply which may vary by state.

     Each spouse has an equal right to manage community property but has exclusive management rights over their own separate property. At divorce, the court has the power to divide community property, but may not reallocate separate property. In Washington, community property must be divided equally.
At death, each spouse has a right to transfer their one-half of the community property. However, if the decedent spouse does not choose to do so, all of the community property becomes the property of the survivor. Again, this discussion is based on Washington.

     From an income tax perspective, it is usually better to have community property. This is due to the “step-up” in basis. At death, all of the property of the decedent gets a basis of the fair market value at their date of death (or alternate valuation date). However, the decedent is deemed to have one-half interest in all of the community property. Thus, both halves of the community property receive a step-up in basis. This is normally desirable. However, though it is named a “step-up” in basis, the basis might be lowered if the fair market value is lower than the basis before death.

     For example, let’s say a couple owns Blackacre with a basis of $100,000 and a value of $1,000,000. Excluding any possible discounts, each half of the property has a basis of $50,000 and a value of $500,000. If it is not owned as community property, the decedent’s half gets a basis of $500,000 while the survivor’s half retains a basis of $50,000. Thus, the combined basis of the property would be $550,000. If the property were community property, each half would get a basis of $500,000 for a total basis of $1,000,000. This is called a “double step-up” in community property states and is typically a major advantage to that form of ownership.

     In addition, Alaska allows you to elect into community property for property held in a community property trust. Other states may follow Alaska’s lead and legislation is pending elsewhere to do so.