Location, location, location is not just vital in real estate. Where you live also can have critical tax implications for your taxes, especially for married couples.
There are two very different kinds of property ownership law for married couples in the United States: common law and community property law. Numerous variances exist in the particulars of these property ownership styles across the many states, but some general rules apply in each case. Any state that is not a community property state is a common-law state.
Community property states offer a distinct tax advantage for couples’ assets when one spouse dies. But if you live in a common-law state, there’s some good news: Several states have passed statutes empowering married couples living in any common-law state to establish a community property trust with a qualified trustee. The advantage they can gain is a step-up in cost basis at each death, something not previously available in common-law states.
Community property states
First, let’s briefly discuss what “community property” means. Nine states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin — operate under community property laws, as does Puerto Rico. Under community property law, each member of a married couple owns one half of all the property, with all the rights of ownership. Usually, it is presumed that all property acquired during a marriage is community property, except property acquired by gift or an inheritance. But the law varies greatly among the community property states regarding some important matters — for instance, whether one spouse may identify some property as community property without the other spouse’s consent and whether an unsecured creditor can claim against any community property if both spouses did not sign the guaranty.
Under federal income tax law, IRC § 1014(b)(6), all community property (including both the decedent’s one-half interest in the community property and the surviving spouse’s one-half interest in the community property) receives a new basis at the death of the first spouse equal to its fair market value; in other words, the cost basis is stepped-up, and the assets may be sold without recognizing a capital gain.
Property in the sole name of the second spouse to die can receive a second step-up in basis, but there is no second step-up for those assets that were placed into irrevocable trusts prior to the second death (such a trust may be needed to shelter assets under the lifetime estate tax exemption or to qualify assets for the unlimited marital deduction, commonly referred to as A-B trust planning).
Under common law, married couples generally own assets either jointly or individually. When the first spouse dies, assets in the decedent spouse’s name, or in the name of a revocable trust, are stepped-up. Assets held jointly at death only receive a step-up in basis on half the property. And the assets in the surviving spouse’s sole name are not stepped-up. However, when the surviving spouse dies, assets held in his or her sole name can get a step-up in basis. Again, this doesn’t apply to assets placed into irrevocable trusts before death.
With the portability of the lifetime estate tax exemption, most couples seek trust planning for financial organization and professional administration of wealth. A-B trust planning may be beneficial to shelter assets that are expected to grow substantially after the first spouse dies or when the first spouse to die wants to tie up those assets for his or her descendants in case the surviving spouse remarries and might decide to favor a second family.
Common-law states offering community property trusts
So far, five common-law states have passed community property trust statutes that empower a married couple to convert common-law property into community property. They are:
The purpose of community property trusts is to allow married couples living in the resident state and others living in common-law states to also obtain a stepped-up basis up to all assets they own at the first death, just like in community property states. Residents who live in a common-law state that does not offer this trust solution may still execute a community property trust in one of the community property trust states but must appoint a qualified trustee in that state.
The Tennessee Community Property Trust
Because I’m an adviser for a Tennessee-chartered trust company, I can only speak to the specifics of one community property trust: the Tennessee Community Property Trust. However, understanding how this trust works will generally prepare residents of other common-law states to consider this strategy.
The Tennessee Community Property Trust Act (TCPTA) of 2010, Tennessee Code Annotated, Section 35-17-101, et seq., allows married couples to convert their individual assets into community property. Each spouse is deemed to own an undivided one-half interest in every asset of a community property trust. Therefore, IRC § 1014(b)(6) (described above) applies in the same way as with community property states to provide a step-up in basis to the date of death value for the entire community property trust at the death of the first spouse to die.
Under the TCPTA, a community property trust can be voluntarily funded with some or all the couple’s assets, with no requirement that assets be marital property. The grantors may transfer any property owned jointly or solely by either party into the trust. The grantors will determine their rights and obligations in the trust assets, regardless of when and where the property is acquired or located, the disposition of those assets upon dissolution, death or another event, and any other matter affecting trust property that does not violate public policy.
To qualify under the TCPTA, a community property trust must follow certain rules:
Both spouses must be grantors.
The trustee must be a qualified Tennessee trust company, bank, or resident, including either or both spouses who reside in Tennessee.
The trust must divide the assets equally if they divorce or must include terms that address the division in the event of divorce.
The trust will be subject to creditors’ claims, but only one-half the assets are subject to each spouse’s creditors.
The grantors must be able to distribute or remove trust assets at any time, and such assets will no longer be community property.
The grantors may jointly amend or revoke a community property trust at any time. A single grantor may amend the trust to alter how that grantor’s assets will be disposed at death and may revoke the entire trust without the other grantor’s consent. The trust can be written to preserve other purposes that may be amended as well.
At the first death, the trust assets must divide into a survivors’ share and a decedent’s share. These shares may then fund an irrevocable survivor trust and an irrevocable marital trust for the benefit of the surviving spouse. Both these trusts will obtain another step-up in basis at the surviving spouse’s death if properly drafted. They will therefore avoid federal capital gain taxes for trust assets sold by a surviving spouse and, again, avoid federal capital gain taxes when assets are sold by the surviving spouse’s trust beneficiaries.
Also, the couple’s joint estate tax lifetime exemptions may be applied to shelter the trust assets from the estate tax if certain strategies are employed. The surviving spouse may be granted a general power of appointment in the survivor’s trust and may hold an unlimited right to withdraw all the survivor’s trust assets. The surviving spouse may also elect that all or a fractional part of the marital trust will be treated as a qualifying marital deduction trust or as qualified terminal interest property (QTIP).
Applying these strategies will cause each of the survivor’s trust and the marital trust to be includable in the surviving spouse’s taxable estate for income and estate tax purposes, subject to his or her lifetime estate tax exemption (plus any unused decedent spouse’s exemption) and allow the desired step-up in basis at his or her death.
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