Community property has tax advantages that are not available to other forms of ownership. Spouses that hold title as community property can save substantial taxes following the death of a spouse. The characterization as separate or community property can be specified in the deed and other transfer documents.
Tax Benefits of Holding Title as Community Property
Many couples want to hold title as community property for tax purposes. The reason has to do with a tax concept known as basis. You can think of basis as the amount you can recover tax-free on the sale of a property.
For example, if you have a $90 basis in a property and sell it for $100, you will only pay tax on the $10 difference between your basis and the sale price. The $100 sale price is offset by the $90 basis, leaving you with only $10 in taxable gain.
$100 Sale price
-$90 Basis
$10 Taxable Gain
Section 1014(b)(6) if the Internal Revenue Code has a special rule for community property: On the death of one spouse, 100 percent of the basis of community property is “stepped up” to fair market value. A step-up in basis has the practical effect of erasing all appreciation in property.
Assume a married couple owns real estate in a community property state with a basis of $20,000 and that the property is worth $100,000. If the couple sells the property, they would pay tax on $80,000 in taxable gain (the difference between the $100,000 sale price and the $20,000 basis).
$100,000 Sale price
-$20,000 Basis
$80,000 Taxable Gain
If, instead of selling the property, the couple holds the property until the husband’s death. On the husband’s death, the $20,000 basis is stepped up to the property’s value ($100,000). As a result, there is no difference between the fair market value and the basis of the property. If the wife then sells the property for its fair market value, she will have no taxable gain on the sale.
$100,000 Sale price
-$100,000 Basis
$0 Taxable Gain
Comparison to Common Law/Separate Property States
A different rule applies in states that do not recognize community property (called common law or separate property states). In separate property states, the basis step-up only applies to the deceased spouse’s proportionate ownership of the property. This often results in a step-up of only one half of the property’s basis.
Using a variation of the example above, assume a married couple owns real estate in a separate property state with a basis of $20,000 and that the property is worth $100,000. In a separate property state, each spouse is considered to own a portion of the property separately (usually one half). On the death of a spouse, only that spouse’s one-half interest would receive the basis step-up. As a result:
- The basis in deceased spouse’s one-half interest would be stepped up from $10,000 (one half of the basis before death) to $50,000 (one half of the property’s value).
- The basis in the surviving spouse’s one-half interest would remain at $10,000 (one half of the basis before death).
This means that the basis in the property would only be stepped up to $60,000 after the first spouse’s death. If the spouse then sells the property, she would recognize $40,000 in taxable gain.
$100,000 Sale price
-$60,000 Basis
$40,000 Taxable Gain
Compared to a community property state (where no gain resulted from the sale due to the full basis step-up), this result is considerably less favorable.
Obtaining Community Property Status
There are three ways that spouses can create community property interests that qualify for the full basis step-up under Section 1014(b)(6) if the Internal Revenue Code:
- The spouses can acquire title to the property as community property in a community property state.
- The spouses can convert separate property to community property in a community property state.
- The spouses can use a community property trust or community property agreement in a state that allows these documents, as long as the spouses meet residency and other requirements.
Each of these options are discussed in more detail below.
Property Characterized as Community Property Under State Law
If the spouses acquired real estate in a community property state and the real estate is community property—which is usually the case if the property is not acquired by gift or inheritance or purchased with separate funds—the property will be eligible for full basis step-up.
In community property states, specify that the property is community property at the time of the deed. Although status can be converted at a later time, the best option is usually to include special language in the deed that identifies the marital status of the spouses.
Converting Separate Property to Community Property in a Community Property State
Spouses in a community property state—like Texas or California—may nonetheless hold title as separate property. This could occur, for example, if a spouse owned property before the marriage or inherited it from a parent or relative during the marriage.
In these situations, spouses may wish to convert separate property to community property to take advantage of the favorable tax laws that apply to community property. This can have several important non-tax consequences, though, including different results upon death or divorce. Spouses should ensure that they are comfortable with the non-tax consequences before converting property from separate property to community property.
Use of Community Property Trusts or Community Property Agreements
Alaska is not a community property state, but Alaska law allows residents to opt-in to community property arrangement through a community property agreement or community property trust. Tennessee law also allows spouses to form community property trusts to create a community property relationship.
The enactment these opt-in laws in Alaska and Tennessee law were motivated in part by a desire to obtain the tax benefits associated with community property. Sometimes an Alaska or Tennessee Community Property Trust can change the character of property from separate to community property.
The IRS has never publicly recognized these relatively new forms of community property opt-in. These are advance techniques that should be discussed with an attorney.