Key Takeaways
- Community property encompasses any property acquired by either spouse during their marriage and may include assets such as real estate, investment accounts, bank accounts, and more.
- A community property trust provides both spouses with the ability to control the management of assets and revoke or amend the trust rather than place all the power in the hands of one spouse.
- Possible benefits of a community property trust include the ability to secure separate property as community property, provide spouses with joint control over important assets, and reduce capital gains taxes.
- To understand how a community property trust may influence the trust administration process or how to address disputes, it’s advisable to seek the support of an experienced trust administration or litigation attorney.
Introduction
In a community property state like California, community property trusts can be a beneficial estate planning tool for married couples. These types of trusts offer potential advantages like the ability to reduce capital gains taxes and provide both spouses with security over who manages these assets both before and after the death of a loved one.
However, as with any estate planning tool, it’s vital that you fully understand when these trusts are most useful and whether their potential advantages align with your estate plan. Understanding what a community property trust is and how you may be able to use it can give you insight into whether the potential benefits are valuable for your family’s estate.
What is Community Property?
Community property is any property that is acquired during the course of a marriage and is legally considered to belong to both spouses. In cases of community property, both spouses share a 50/50 ownership over the property unless otherwise stated by a separate law or agreement—the exception to this rule is that if the asset acquired during marriage is an inheritance account or a gift, it is still considered separate property.
The following assets are commonly subject to community property laws:
- Income
- Bank accounts
- Investment accounts
- Retirement plans
- Real estate property
For example, if a married individual buys a car with her own money, the car is still considered community property that belongs to both her and her husband, each entitled to a 50/50 value of the car if they are to divorce.
Community property laws may vary by state, as not all states follow the same terms and are considered common law states. California, however, is a community property state, meaning that any property acquired during marriage is considered to belong to both spouses equally.
How Does Community Property Differ From Separate Property?
Community property is distinct from separate property in that community property belongs in title to both spouses regardless of who purchased the property if acquired during the course of the marriage. Meanwhile, separate property is acquired by one spouse prior to marriage and, in title, is considered the sole property of the person who purchased it.
Other distinctions to consider between the two types of property include:
- Upon the death of a spouse, community property undergoes a full step-up regarding income tax basis, while separate property does not and can potentially lead to reduced financial value for the surviving spouse.
- Any income generated from an asset classified as separate property, such as dividends or interest, will continue to be considered a separate designation unless the couple agrees otherwise.
- Retirement plan accounts must be held in the name of the employed spouse, but this status does not undermine the community interest of the other spouse.
To avoid disputes over property characterization or ownership, it’s important to clearly indicate the ownership status of the property on the title, in the trust agreement, or in other legal documents.
What Is Quasi-Community Property?
Quasi-community property refers to assets acquired by either spouse during marriage while living in a non-community property state before moving to a community property state. In other words, this is any property that would be considered community property if it were acquired while living in California or another community property state. This property would then be treated like community property in cases of divorce and death.
For example, if a couple who moves to California transfers investment funds earned during marriage from a separate property state, those funds are classified as quasi-community property. Upon the death of the spouse who initially acquired the property, the quasi-community property is treated the same as community property and transferred in its entirety to the surviving spouse. However, the property would be taxed as the separate property of the acquiring spouse for federal estate and income tax purposes.
What Is a Community Property Trust?
A community property trust is a single joint trust established by married couples to combine both parties’ assets into one umbrella trust. Upon its creation, all property within the trust is classified as community property. Unlike a standard revocable living trust, a community property trust is not owned by a single party and is instead owned and managed jointly by both spouses.
This trust may include only the community property assets or can be funded with separate property from either side, depending on the property that each spouse chooses to fund into the trust. Upon the death of both spouses, control over the trust will be placed into the hands of a trustee identified by the spouses in the trust agreement.
A community property trust may be established in both community property states and in some common law states where community property is not typically recognized. However, not all states recognize community property trusts. Fortunately, California is one of the states that does.
Benefits of Community Property Trusts in California
By allowing couples to consolidate their assets in a single joint trust, community property trusts can offer some of the following benefits.
Step-Up in Basis at Death
Community property trusts can promote a greater value of assets under step-up basis laws, which can save families substantial amounts in avoiding capital gains taxes. With most assets, the base value is considered to be the market value at the time of purchase—in this case, any gains made on the asset from this initial purchase price will be subject to capital gains tax.
However, in the case of a community property trust, assets step up to their market value at the time of death, which can significantly decrease the capital gains tax liability of the spouse who inherits assets. For example, if one spouse owned an investment account valued at $4,000 at the time of purchase and it rises in value to $50,000 before it is inherited by the surviving spouse, the surviving spouse must pay taxes on the $46,000 gains if they choose to sell the stock.
With a community property trust, however, the account will step up to a base value of the market value of the stocks on the date of death. If the stock is valued at $50,000 when the spouse who acquired the investment passes away, it will be taxed only on any gains exceeding this amount.
If the surviving spouse chooses to sell the stock immediately after they assume ownership, they will not be subject to any capital gains taxes. Or, if they choose to maintain the stock, they will only be subject to capital gains taxes on the amount earned above $50,000 from the date of death forward.
Protection of Assets for Surviving Spouses
A community property trust protects assets for the surviving spouse by offering both partners control over the trust and the assets within it. In a separate property trust, separate property may be distributed according to separate property rules, which only entitle the surviving spouse to 50% of the assets.
As a result, the surviving spouse may only receive a partial inheritance of separate property. Circumstances such as a previous marriage, previously established trusts, and surviving children can all pose risks to the surviving spouse’s inheritance and reduce their access to assets left behind by the decedent. A community property trust allows both spouses to have a 100% stake in the trust’s assets so that they have full rights to all identified assets within it upon the death of one spouse.
A trust is also beneficial for clarifying the terms of the distribution of assets, allowing these assets to avoid the probate and estate administration process. Probate can be costly, time-consuming, and run the risk of assets being distributed according to state intestacy laws, which may conflict with the wishes of the decedent.
Shared Control Over Trust
In a community property trust, both spouses are considered grantors of the trust and maintain control over the trust and its assets. As such, both parties maintain the ability to make trust modifications or revoke the trust at any time. This arrangement offers the benefit of not providing one side with more control or authority over the other. It also helps to minimize legal conflicts in the future if there are future changes to estate plans or the wishes of either party, as both parties will have the ability to make these changes.
Common Law States
In common law states, a surviving spouse does not have the same right to community property. By law, these states assert that any property acquired during marriage is still considered separate property titled to the person who acquired it alone.
Residents of common law states who prefer that their surviving spouse maintain control over these assets may establish a community property trust in a state that allows them, such as California. It’s important, however, to appoint a trustee who has experience in the state where the trust is to be held to ensure that these assets are properly protected and managed responsibly to maximize the benefits of such an arrangement.
Requirements for Establishing a Community Property Trust in California
If you believe that a community property trust is in your best interests, you should consider the following requirements.
Funding Property
The key component of a trust is that you must have property to fund the trust upon its initial creation. For example, when creating a trust, you may consider placing assets such as a vacation property, an investment account, or your primary residence under the ownership of a trustee within the trust.
Keep in mind that property cannot be placed into two separate trusts—if you have property existing in a previous trust, you must remove it before you can add it into the community trust. This is easier if the existing trust is a revocable living trust. If you have an irrevocable trust, you will need to obtain consent from all beneficiaries who have an interest in the trust.
Necessary Documentation
Upon creating the trust, the grantors must provide all necessary documentation that corresponds to the trust. This documentation includes a trust instrument that identifies all assets that are incorporated in the trust and clearly outlines how property should be distributed following the death of one or both spouses. The trust instrument should also include the titles of all property to be placed under the ownership of the trust.
Legal Considerations
A community property trust can have significant implications for the rights and benefits of each spouse regarding community property by influencing how property is characterized. The terms of a trust may also be affected by changes in circumstances, such as a divorce or the birth of a child, making it important to set clear legal foundations for the trust and how it should operate.
Keep in mind the following legal considerations:
- Both spouses must be grantors of the trust
- In California, even if community property assets acquired during marriage are removed from a trust, they will still be subject to community property laws
- As with any community property trust assets, the trust is liable for any outstanding debts that must be resolved
- Community property trusts must be handled carefully under terms laid out by the IRS
It is also advisable that each spouse is represented by separate legal counsel when preparing a community property trust agreement, so that they each obtain legal guidance that considers their best interests.
Suitable Assets for Community Property Trusts
Community property trusts are more amenable to certain types of assets than others. Below are some of the most common types of assets that can be included in community property trusts.
Real Estate
Real estate property is owned equally by both spouses when the property is purchased during the course of the marriage. Real estate is also subject to the capital gains tax. In other words, real estate property will step up to a new basis equal to the fair market value at the time of one spouse’s death. This is particularly beneficial for real estate that is expected to appreciate in value after its acquisition.
Investments and Financial Accounts
Investment and financial accounts are often subject to capital gains taxes, as they increase in value over time due to investment gains or interest accrual. As a result, these assets are valuable to place into a community property trust, as the surviving spouse may benefit from the step-up basis rules that minimize capital gains tax liabilities. A community property trust will allow these accounts to be held jointly for the benefit of both spouses.
Under federal law, some accounts, such as retirement plan accounts, must be held in the name of the employee spouse. However, this does not affect the community interest of the spouse who is not listed on the account. In other words, even if a surviving spouse’s name is not on the account held in a community property trust, they still are entitled to the assets upon their spouse’s death.
Business Interests
Business interests are also a viable option for community property trusts. Any income derived from the business can be classified as community property so that the surviving spouse maintains the right to acquire this property upon the death of their spouse. If a business generates substantial income, the surviving spouse will also be able to benefit from the step-up basis rules, which can help minimize any potential capital gains taxes they may be liable for due to the business’s appreciation in value.
Impact of Community Property Trusts on Divorce Proceedings
During divorce, community property trusts are handled the same as any other community property assets. In divorce proceedings, community property is typically divided in a 50/50 split.
However, both parties may choose to negotiate a division of property under unique terms. For example, if each spouse has a unique interest in different pieces of community property, they may negotiate to split the property between them, even if these properties do not have equivalent value. A community property agreement may also be used to set an agreement for how assets should be divided in the event of a divorce.
In some cases, a spouse may choose to also create a separate property trust for any separate property they do not want to be considered community property. In this case, a separate property trust may be able to protect assets from being split 50/50 during divorce. It’s advisable to consult a trust administration attorney to understand the legal implications for a trust established prior to divorce.
Who Should Consider Creating a Community Property Trust?
A community property trust may not be the most viable option for everyone, but it may be most beneficial for couples in the following situations.
Couples in California
Married couples in California may benefit from a community property trust due to the tax benefits and the ability to preserve the surviving spouse’s interests in separate property. By placing assets into a community property trust, the surviving spouse is guaranteed to receive 100% of the property upon their spouse’s death, with little room for dispute. At the same time, they will also benefit from being able to save on capital gains taxes due to the step-up basis rule.
Married couples moving to California who have assets from a common-law state may also consider placing separate property into a community property trust so that all property can be divided according to community property rules upon the death of a spouse. By placing these assets into a community property trust, the surviving spouse will have a claim to 100% of the property upon their spouse’s death.
Estate Planning for Blended Families
A community property trust may also be a beneficial option for married couples with blended families after a second marriage. If one or both spouses have their own separate property and have children from previous marriages, a community property trust can simplify asset distribution upon the death of a spouse and minimize the risk of trust disputes.
For example, a community property trust can be used to protect designated assets from division amongst other interested parties while also ensuring a stepped-up basis to reduce capital gains taxes for surviving relatives.
In a traditional arrangement, children of a decedent have a right to an equal share of separate property as the surviving spouse. However, any assets placed into a community property trust will be considered the property of the surviving spouse, which can protect any assets that they have a unique interest in from being divided amongst other interested parties, like children from a previous marriage, unless it aligns with the decedent’s wishes.
Considerations for High-Net-Worth Individuals
High-net-worth individuals often utilize irrevocable trusts to protect their assets from creditors and potentially reduce the estate taxes their assets may be subject to. The step-up basis is often considered one of the most significant potential benefits of a community property trust for high-net-worth individuals.
Wealthy individuals often have a complex asset portfolio of high-value property spread out across multiple jurisdictions. Complications can arise in the event that there are disputes about who should inherit property—a community property trust can ensure that the property is protected for the surviving spouse.
It is essential that these individuals have a rigid estate plan that clarifies how their assets should be administered in a trust so they can not only avoid potential disputes between heirs but also maximize the value of the trust for their heirs. Consider discussing your estate plan with an experienced estate planning attorney. Then, once you establish a trust, consult a trust administration attorney to verify that there are no holes in the estate plan.
Navigate Community Property Trusts With the Help of RMO Lawyers
A community property trust may offer the benefits of giving both spouses clear control over jointly owned assets while also providing tax advantages. However, this unique estate planning tool may lead to some questions or concerns during the trust administration process, making the advice and guidance of an attorney valuable.
With decades of experience in trust administration, the lawyers at RMO LLP may be able to support you in navigating the administration process. Our attorneys will work closely with you to understand your estate plan and devise an administration strategy to uphold the best interests of your and your spouse’s estate. If you experience a trust dispute during the process, our attorneys are ready to support you during litigation.
Schedule a consultation with the attorneys at RMO LLP to discuss your case and how we can support you.
Glossary
Community property – Any assets or property acquired by either spouse during marriage that is considered to belong to both spouses equally.
Common law state – A state with laws that direct that any property acquired by either spouse during marriage remains the separate property of the spouse who purchased it.
Community property state – A state with laws that direct that any property acquired by either spouse is considered to be shared and owned equally by both spouses, exempting gifts or inheritance.
Community property trust – A form of trust designed to protect both spouses’ interests in all community property by giving both spouses control over the terms of the trust and the assets within it.
Probate – The court process in which the assets of an estate are gathered, accounted for, and distributed to the heirs or beneficiaries after an individual passes away, either in accordance with the deceased’s wishes if they had a will or following local intestacy laws if there was no will.
Quasi-community property – Any assets or property acquired by a spouse during marriage but before moving to a community property state.
Trustee – A person who coordinates the administration of the trust, manages the trust’s assets and is responsible for distributing the assets to the trust’s beneficiaries.