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- Estate Planning Basics
- Fundamental questions
- Will or living trust?
- Other facts about estate settlement
- Determining potential estate taxes
- Estate Tax Saving Strategies
- The marital deduction
- Life Insurance
- Annual gifting
- Charitable contributions
- Strategies for family-owned businesses
- Special strategies for special situations
- Community property issues
- Implementing and Updating Your Plan
- Where do you go from here?
- Estate planning worksheet
- Planning Levels Fee Schedule
COMMUNITY PROPERTY ISSUES
Ten states have community property systems: Alaska (elective), Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Under a community property system, your total estate consists of your 50% share of community property and 100% of your separate property. What’s the difference?
Community property usually includes assets you and your spouse acquire under two conditions: 1) during your marriage, and 2) while domiciled in a community property state. (See Planning tip 8.) Each spouse is deemed to own a one-half interest in the community property, regardless of who acquired it. For example, wages and other forms of earned income are treated as community property, even if earned by only one spouse.
Separate property usually includes property you and your spouse owned separately before marriage and property you each acquire during marriage as a gift or inheritance that you keep separate. In some states, income from separate property may be considered community property.
In most community property states, spouses may enter into agreements between themselves to convert separate property into community property or vice versa. This can be an important part of your estate plan, but improper agreements or incorrect transfers can lead to unwanted results.
Remember, marital rights are expanded
Community property states start out with greater protection for the surviving spouse because he or she is deemed to own 50% of any community property interest. But some states go much further, and the laws can be complex. For example, rules may vary depending on how many children you have and how much the surviving spouse owns in relation to the decedent.
In some cases, the surviving spouse is entitled to full ownership of property. In other situations, he or she is entitled to the income or enjoyment from the property for a set period of time. Seek professional advice in your state, especially if your goal is to limit your surviving spouse’s access to your assets.
- Planning tip 8
- Determine Your Domicile
There is no one definition or single set of rules establishing domicile. Because you can have a residence in, and thereby be a resident of, more than one state, domicile is more than just where you live. Domicile is a principal, true and permanent home to which you always intend to return, even if you are temporarily located elsewhere.
Plan carefully when using a living trust
If a living trust is not carefully drafted, the property may lose its community property character, resulting in adverse income, gift and estate tax consequences. For example, improper language can create an unintended gift from one spouse to the other. To avoid any problems, the living trust should provide that:
- Property in the trust and withdrawn from it retain its character as community property,
- You and your spouse each retain a right to amend, alter or revoke the trust, and
- After the death of one spouse, the surviving spouse retain control of his or her community interest.
Reap the basis benefit
Assets are usually valued in your estate at their date-of-death fair market values. (Sometimes assets are valued six months after death, but only if the estate has dropped in value since the date of death.) For example, stock you purchased for $50,000 that is worth $200,000 at the time of your death would be valued in your estate at $200,000.
The good news is that your assets receive a new federal income tax basis equal to the value used for estate tax purposes. (In 2010, with the estate tax repeal, the step-up in basis will be limited. But the laws are complex, so consult a professional advisor on how this change will affect your estate plan.) In our example, your heirs could sell the stock for $200,000 and have no gain for income tax purposes. Their income tax basis would be $200,000 instead of your $50,000.
- Planning note
- Community Property
Community property owners receive a double step-up in basis benefit.
Community property owners receive a double step-up in basis benefit. If the $200,000 of stock in the previous example were community property, only one-half of the stock ($100,000) would be included in the estate of the first spouse to die. But, the income tax basis of all of the stock rises. Therefore, the surviving spouse could sell his or her 50% share of the stock at no gain, as well as the decedent’s 50% share.
Sometimes the basis rule works against you. If property is valued in your estate at less than the cost to you, the heirs still receive an income tax basis equal to the date- of-death value. If you had purchased stock for $75,000 that was valued in your estate at $50,000, your heirs would receive a basis of $50,000. If the heirs later sold the stock for $100,000, they would have to realize a gain of $50,000 ($100,000 – $50,000) rather than a gain of $25,000 ($100,000 – $75,000).
Watch out for unwanted tax consequences with ILITs
Several community property state issues must be taken into account to avoid unwanted tax consequences when an ILIT owns a life insurance policy. These relate to who owns the policy before it is transferred to the trust, whether the future premiums are gifted out of community property or separate property, etc.
For example, if you gift an existing policy that was community property to an ILIT and the uninsured spouse is a beneficiary of the trust, the estate of the surviving uninsured spouse could be taxed on 50% or more of the trust. However, proper titling of the policy, effective gift agreements between spouses and proper payment of premiums can avoid this problem. Be sure to get professional advice on these arrangements.
Distinguish between separate and community property for FLPs
For community property state residents, it is important to state in the FLP agreement whether the FLP interest is separate or community property. In addition you should consult your attorney to determine if a partner’s income from an FLP is community property or separate property.
- Planning note
Community property can be the perfect vehicle for generation-skipping transfers.
Get spousal consent before making charitable gifts
Under the community property laws in many states, a valid contribution of community property cannot be made to a charity by one spouse without the consent of the other spouse. Consent should be obtained before the close of the tax year for which the tax deduction will be claimed.
Enjoy easier generation-skipping transfers
Community property can be the perfect vehicle for generation-skipping transfers. In 2006, a married couple with $4 million of community property would qualify for effective use of this strategy without needing to transfer any assets to each other.
Weigh your property treatment options
You don’t always have to follow the property system of your state of domicile or the state in which you buy real estate. For example, if you live in a community property state and want to avoid having to obtain your spouse’s consent to sell or make gifts of community property, you may elect out of community property treatment. But you also can retain community property treatment if you move from a community property state to a separate property state.
To do this, consider establishing a joint trust to hold the community property when you move to the new state or simply prepare an agreement outlining the status of the assets as community property. But you must ensure the community property assets remain segregated. If they become intermingled with separate property assets, you could lose the community property status.
Another option is to leave assets in a custody account governed by the laws of the community property state. It may be possible to retain the community property nature of the assets by simply segregating them from other assets on arriving in the new state, but the estate planning documents that dispose of the segregated assets should provide for the disposition of only one-half of the assets at the death of each spouse.
Be sure to execute similar strategies if you have separate property that you wish to remain separate when you move to a community property state. Again, to retain its separate property status, it cannot become intermingled with community property. Make a well-thought-out decision about how you would like your property to be treated.
If you aren’t concerned about the limits on community property and are interested in obtaining its tax advantages but don’t reside in a community property state, consider taking advantage of the Alaskan system, which allows nonresidents to convert separate property to community property. Note that implementing such a decision is complex, involves placing property in trust, and requires careful planning and coordination with your advisor.