If you are a married individual living in a community property state, you might be able to benefit from the income tax advantages of holding property as community property.
What is community property?
Married individuals living in community property states can own property in one of three ways:
- Separate property, which is property held individually by one spouse
- Community property, which is property held jointly by the spouses
- Quasi-community property, which is property that would be community property if the spouse acquiring the property lived in the community property state at the time of acquisition
Generally speaking, all income earned or assets acquired by either spouse during marriage in a community property state is considered property of the ‘community’ -- that is to say, property of the married couple. Notwithstanding a few exceptions, each spouse by default owns a 50% share in that income or those assets.
How does community property deliver tax advantages?
Community property can provide married individuals with certain income tax benefits that are not available to separate property.
When a spouse dies owning separate property, that separate property receives an adjustment in basis for income tax purposes up to the fair market value at the date of death, known as a step-up or step-down in basis. Separate property held by the surviving spouse retains its basis and is not affected by the first spouse’s death.
When a spouse dies owning community property, both the deceases spouse’s ½ share and the surviving spouse’s ½ share in the community property are stepped up or down to the current fair market value. For a community property asset that has gained considerably in value, this means that the surviving spouse could sell the community property asset shortly after the death of the first spouse paying little or no federal or state capital gains tax.
Example of the Tax Benefits of Community Property
Jack and Jill are a married couple living in California. They jointly own a home that they purchased a few years back for $400,000. The house is now worth $500,000.
Jack passes away, and in his estate plan gifts his share of the house to Jill. Jill sells the house a few days after Jack’s death for $500,000.
Scenario 1: Separate Property
Suppose Jack and Jill own the house as separate property, such as in joint tenancy, with 50% owned by Jack and 50% owned by Jill.
When Jack passes away, his estate plan gifts his 50% share to Jill, who now owns 100% of the house.
The cost basis of Jack’s 50% share that Jill inherits is increased based on the new fair market value of the house to $250,000 (50% of $500,000). This means that Jill’s cost basis in the home is now $450,000, equal to Jill’s original $200,000 cost basis and the new $250,000 cost basis from Jack’s gifted share.
When Jill sells the house for $500,000, she pays taxes on her capital gain of $50,000 (the $500,000 value of the house, less the new $450,000 cost basis).
Scenario 2: Community Property
If Jack and Jill own the house as community property, Jack owns a 50% share and Jill owns a 50% share.
When Jack passes away, his estate plan gifts his 50% share to Jill, making Jill the sole 100% owner of the house – just like in the prior separate property example.
Since the couple held the house as community property, the cost basis of both Jack’s 50% share and Jill’s 50% share increases to the new fair market value at Jack’s death. This “double step-up” means that Jill’s cost basis in the home is now $500,000.
When Jill sells the house for $500,000, she has no capital gain, because her new cost basis in the house is equal to the sale price. Jill does not need to pay any capital gain tax on the sale of the house!
Community Property and Estate Planning
The potential tax benefits of holding property as community property can be substantial, which is why many married couples living in community property states elect to hold and preserve their property as community property. Certain common law states like Florida also allow residents to make a special election to treat property as community property, which can be similarly advantageous.
Nonetheless, the potential tax savings is certainly not the only consideration a married couple should consider when holding property as community property vs. separate property. Separate property typically confers greater asset protection than community property, and individuals who enter into marriage with vastly different net worth may wish to keep their property separate in the event of divorce or to accommodate different gifting goals upon death.