Unless you have a reason to be familiar with state property laws, you may not know that the way property is owned by a married couple differs depending on the state you live in. How your state treats property in a marriage is helpful to know when you are preparing your finances before marriage or before making an estate plan, especially if it is important to you to retain separate ownership of an asset or if you are interested in possible tax consequences. So what should you know if you life in a community property state?
Community Property States
Nine states are default community property states. Those states include: Arizona, California, Idaho, Nevada, New Mexico, Texas, Louisiana, Wisconsin, and Washington. That may not seem like a lot of states, but these 9 states account for 25% of the population of the United States.
In addition to the 9 default community property states, Alaska has an elective community property regime. A married couple living in Alaska can choose for the community property rules to apply to them by signing a written community property agreement. The agreement must follow certain statutory requirements.
In community property states, spouses are generally considered to share equally in any income, property or debts acquired during the marriage, regardless of who earned or incurred it. However, there are some exceptions to this general rule which are discussed below.
The other states are called comfestatemon law or equitable distributionstates. In equitable distribution states—any state except the 9 mentioned above—property acquired during a marriage belongs to the spouse who earned it or acquired it, unless the property is specially titled in the name of both spouses as co-owners or it was acquired while domiciled in a community property state. If you divorce, a court will generally try to make a fair and equitable distribution of property, as opposed to the 50/50 split that is common in divorces in community property states.
If you live in a community property state—or if you own property in a community property state—here are a few things you should know in case of death or divorce.
1. Who owns what?
In a community property state, property earned or acquired prior to marriage will usually be separate property and will remain separate property even after marriage (unless an agreement or the behavior of the spouses towards the property converts it to community property). On the other hand, most property acquired by either spouse during marriage is owned equally by both spouses.
Income earned during marriage can also be treated as either separate income (and money) or as community income. For example, your earnings during marriage will usually be community income. That means you will each be responsible for taxes on 50% of the income if you file separate income tax returns, for example. Income from real estate that is community property will also be community income.
However, income from separately owned property – such as dividends on stock that you owned prior to marriage, for example – can be either separate income or community income, depending on which state you live in. In Idaho, Louisiana, Texas, and Wisconsin, income from most separate property is community income. In Arizona, California, Louisiana, Nevada, New Mexico and Washington, income from separate property will also be separate income (and will continue to be separate property after its earned).
2. If you want to keep some assets separate, consider a prenuptial or postnuptial agreement or a property characterization agreement.
In the case of either property or income, you may have reasons for wanting to change the way the property or income is treated. You may wish to keep some property or income separate - or to make some separate property or income a community property instead.
If that is the case, you can consider signing either a prenuptial agreement (before marriage) or postnuptial agreement (after marriage) to specify what property or asset is to remain the exclusive property of you or your spouse (or become community property if it would otherwise be separate).
Many states also allow community property, separate property or property characterization agreements. This type of agreement is usually more limited in scope than a prenuptial or postnuptial agreement, but it can change the default ownership rules that apply to some or all of the property you acquire during marriage.
These agreements are only effective if they are correct under state law – so you should consult with an attorney in your area before signing one.
3. Any inheritance or gift you receive during marriage from a third party during marriage is your separate property.
Despite sharing other income and property equally, if you receive an inheritance or a gift given by a third party specifically to you during marriage (and if you don’t have an agreement with your spouse that says otherwise), that gift or inheritance is your separate property. It is not community property unless you choose to treat it as such.
4. There are other ways for property to remain separate.
If your spouse came into the marriage with debt, and your joint income is used to make payments on the debt, then that means that community property (the joint income) was used to pay off or pay down separate property (the pre-marital debt). If you and your spouse end up divorcing, you could be reimbursed for part of that amount as part of the divorce settlement.
If you or your spouse acquire property or earn income after a legal separation, that property may be treated as separate property, depending on the rules in your state, your separation decree, and whether both of you are listed on the property’s title or deed.
Other separate property includes educational debt (usually – some exceptions apply where the degree benefited the marital community), tort liability for activity not done for the benefit of the marital community, or a personal injury award (it becomes separate property if you divorce).
5. Separate property can become community property.
There are a few ways for separate property to become marital/community property. It may not be an important issue for you, but be aware that these things can convert your property to marital property, especially if keeping it separate is important to you.
- Adding your spouse to the title of a separate property that you owned before marrying can make the property community property rather than separate property.
- Taking out new property loans, refinancing, or making modifications to your loan could make your separate property community property.
- Using marital money to improve a separate asset can make the value of the improvement a marital asset.
- Co-mingling separate property with marital property can make it marital property.
- Aid or help from one spouse to another which enables a spouse to maintain or run a business may convert any equity in the business into marital property. For example, if one spouse works at a small company in which she owns stock, and the other spouse runs the household, the spouse who stays home may have a marital property right in the stock – even if it was stock initially acquired prior to marriage.
6. Gifts from community assets should be made with the agreement of both spouses.
Small gifts are unlikely to come up in court, but if you make a large gift with joint funds or community property assets to a person or organization, you are better off obtaining written consent from your spouse before doing so. Because most income is shared jointly and community property is owned jointly, a gift of your earnings or assets should also be shared jointly, and you need to have your spouse’s consent.
Keep in mind that some gifts (usually only if more than $28,000 to any one person if the gift is made from community property) will trigger a gift tax filing obligation. If you are thinking about making any large gifts, it’s a good idea to first consult with an accountant or attorney.
7. An income tax advantage.
When one spouse dies, they can pass half of the community property and all of their separate property to whomever they choose (via will or trust). The surviving spouse remains the owner of the other half of the community property – which may include property that was titled only in the name of the deceased spouse but which was acquired during marriage.
The community property carries a major income tax advantage. In equitable distribution states, generally only the separate property belonging to the deceased spouse and half of any jointly owned property receives a step-up in tax basis. However, in community property states, the separate property belonging to the deceased spouse AND 100% of the community property – meaning both the half retained by the surviving spouse and the half that is included in the deceased spouse’s estate - receives a full step-up (also called “double step-up”) in tax basis.
Tax basis is important because it is used to determine how much gain you realize when you sell an asset and receive profits that are part of your income. Usually, the amount of your gain will be the difference between your selling price and your “basis.” Tax basis is usually what you paid for the property (subject to certain adjustments). Thus, if you buy stock that cost $10,000 and sell it for $12,000, your taxable gain would be $2,000.
However, when someone dies, property in their estate will usually get a new tax basis – or a “stepped-up” basis. The new basis will (usually) be the fair market value of the property on the day that they died. For property that increases in value over time this is a huge advantage because it means that there will be no income tax on the growth in property value from the day the decedent purchased the property until the day they died.
Couples living in community property states have a major advantage because this step-up in basis applied even to community property owned by the surviving spouse. The surviving spouse could thus, for example, sell an asset shortly after the death of the other spouse and recognize little or no taxable gain.
8. Why you should consider a trust
There are a number of reasons to consider setting up a trust, regardless of where you own property. But there are some additional reasons to consider a trust if you live in a community property state.
For example, you can use a joint revocable trust to preserve your community property status even if you move to another state. The community property tax advantage that allows a person to minimize taxable gain when they sell a marital asset after their spouse passes away is not insignificant. But if you move from a community property state to an equitable distribution state, you risk losing that tax advantage.
To preserve your community property standing, you can set up a joint revocable living trust and fund it with the assets or properties you would like to continue to hold as community property. This type of trust has been recognized by the IRS as preserving community property, but you must make sure that the trust complies with IRS requirements.
You may also want a separate trust to make sure your separate property stays separate and doesn’t become “co-mingled” with marital property or too difficult to trace. If one spouse sets up a separate trust and transfers their separate property to the trust, this should help to avoid potential confusion down the road about the character of that property.
Here at Tomorrow, we offer a trust you can set up in less than a half hour.