Planning for Community Property: A Primer for the Other 40½ States

For otherwise savvy planners practicing outside the community property states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin, and since 1998, Alaska, under a nonmandatory “elective” regime [1] – community property is often the largest “blind spot” in their practices. Although no one seems to keep statistics about this sort of thing, it would not be at all surprising to learn that practitioners in the “other” 40½ states (which Westerners generally refer to as the “common law” states) regularly destroy the significant advantages afforded by their migrating clients’ community property holdings. Community property’s felicitous “built-in” estate equalization properties, the opportunity it affords for fractional interest discounting, and, above all, the “double basis step-up” afforded both spouses’ halves of community property at the death of the first spouse [2] (at least until 2010 [3]), are easily shattered through less than careful planning. Fortunately, with a little focus and some small effort, this loss can be avoided.

Community property is a form of ownership under which each spouse owns a present, equal undivided interest in each asset. While the various state community property regimes differ from one another in many particulars, most share some common principles: (1) property acquired during the marriage, as well as the rents, issues, and profits as to such property, are generally community property [4]; (2) property owned prior to the marriage, or acquired during the marriage by gift or bequest, is generally separate property, of which both “halves” are owned by one spouse [5]; and (3) if there is any doubt as to the character of a particular asset owned during the marriage (as for example if there has been “commingling” of separate assets with community assets), there is a relatively strong presumption that the asset is community property [6]. The fact that record title reflects only one spouse’s name, or indicates a different form of ownership, in general does not defeat this presumption. [7] At death, each spouse is usually entitled to dispose of his or her half of the community property as he or she may wish; the surviving spouse usually does not have an enforceable right to receive the deceased spouse’s community property interest (except in cases of intestacy or when the parties have executed a “community property agreement” providing for “automatic” ownership of both halves by the surviving spouse upon the first spouse’s death). “Widow’s election” wills, under which the first spouse makes provision for the surviving spouse on condition he or she elect against rights in his or her half of the community property, present special problems. Upon dissolution of the marriage, the respective halves of the (formerly) community property are generally to be awarded to each spouse respectively, or at least this is often the starting point in the court’s analysis. Increasingly, community property-like principles are being applied to “meretricious” relationships between unmarried couples. [8] As might be surmised, these are broad generalizations, all of which are subject to exceptions and conditions which tend to vary widely from state to state.

Among the important qualifiers which often affect clients migrating out of community property states, are issues of “quasi-community property” and federal preemption. Many of the community property states treat acquisitions made outside the state which would have been characterized as community property had they been made inside the state, as “quasi-community property,” treated as community property for specified purposes. [9] In contrast to this extension of community property principles, the doctrine of federal preemption works in the opposite direction, removing certain assets from the operation of community property principles. Among other federal enactments, the Railroad Retirement Act [10] and ERISA, [11] have been held to preempt community property laws.

An initial checklist item for the planner will be to ascertain whether the clients have ever resided in a community property state, and if so, whether they have ever signed a “community property agreement.” Such agreements, which may or may not have been recorded, are fairly common in some community property states, designed as they are to help remove some of the uncertainties inherent in the tracing and characterization principles applied in the various jurisdictions. A community property agreement may contain any one or more of the following provisions: (1) all property currently owned is characterized as community property (frequently with separate property exceptions scheduled); (2) all property which either spouse may acquire during the marriage subsequent to the date of the agreement is to be characterized as community property; and (3) at the death of the first spouse, all community property will automatically pass to the surviving spouse, without the need for probate administration. Those agreements containing only the first two of these provisions are commonly called “two-pronged” community property agreements and in general should be kept in place (though, after the couple moves to a common law state, the second prong will need to be reviewed); those agreements containing all three provisions, known as “three-pronged” community property agreements, can cause considerable mischief in taxable estates. While a “two-pronged” agreement can help preserve the advantages of community property, including estate equalization and the double basis step-up at the first spouse’s death, a “three-pronged” agreement, despite its potential advantages in helping avoid probate at the first death, has the distinct disadvantage of bypassing tax-savings provisions in the will or inter vivos trust and rendering them ineffective. Even in the absence of a community property agreement, of course, the clients may own community property, but usually cannot be relied upon to know whether or not they do; the planner must simply dig. Prior extended residence in a community property jurisdiction will often indicate the presence of items of community property.

Once the planner has identified community property assets among the clients’ holdings, the next step is to determine how such assets are treated under the law of the new non-community property state. A growing number of common law states have adopted some version of the Uniform Disposition of Community Property Rights at Death Act. In essence, the Uniform Act provides that, on the first spouse’s death, only that spouse’s one-half interest in the community property assets is subject to the decedent’s testamentary disposition, free of election, dower, or curtesy rights of the surviving spouse. [12] Property not originally community property, but transmuted into community property by spousal agreement, is also subject to the Uniform Act. [13]

In jurisdictions which have not adopted the Uniform Act, planners may be tempted to “resolve” community property questions by having the couple sign a spousal agreement, converting their assets to co-tenancy, an ownership regime more familiar to the common-law state planner. This course is not recommended, as it will likely sacrifice the valuable double basis step-up in both halves of the community property under Code Section 1014(b)(6), in addition to defeating other potential rights and expectations of the two spouses. Simply re-titling assets as tenancy-in-common assets is inadvisable. [14] Instead, the planner should consider any one or more of the following: (1) most simply, memorializing the community property character of the assets via a memorandum or agreement; (2) placing the community property assets in a discrete brokerage account, identified as community property in the ownership documents or in a side memorandum or agreement; or (3) creating a revocable inter vivos trust to be funded with the community property assets, and selecting the law of a community property state as the trust’s governing law.

The 1998 Alaska legislation creates another opportunity for preserving the community property of migrating clients. The Alaska Community Property Act permits non-Alaskans to create a “community property trust,” so long as an Alaskan bank or trust company is named as trustee or co-trustee. [15] The hope is that the assets held in such a “community property trust” will qualify for the double basis step-up at the first spouse’s death. Of course, the Alaska legislation might also tempt planners whose clients have had no connection whatever with community property states, to recommend creation of a “community property trust,” to strive to achieve the same advantages available to those lucky enough to reside in a community property state.

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Endnotes
1. Community Property Act, Alaska Stat. Ch. 34.77.
2. Internal Revenue Code (“Code”) Section 1014(b)(6).
3. Code Section 1014(f).
4. See, e.g., Wash. Rev. Code Section 26.16.030.
5. See, e.g., Cal. Fam. Code Section 770(a).
6. See, e.g., Tex. Fam. Code Ann. Section 3.003.
7. See, e.g., Kitchens v. Kitchens, 407 S.W.2d 300 (Tex. Civ. App. 1966).
8. See, e.g., In re Marriage of Lindsey, 678 P.2d 328 (Wash. 1984).
9. See, e.g., N.M. Stat. Ann. Section 40-3-8(C).
10. Hisquierdo v. Hisquierdo, 439 U.S. 572 (1979).
11. Boggs v. Boggs, 520 U.S. 833 (1997).
12. Uniform Disposition of Community Property Rights at Death Act, Section 3.
13. Uniform Disposition of Community Property Rights at Death Act, comment to Section 1.
14. See Rev. Rul. 68-80, 1968-1 C.B. 348 (loss of double basis step-up for realty titled as tenants in common).
15. Alaska Stat. Section 34.77.100(a)(2), (3).

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