Advantages And Disadvantages Of Community Vs Separate Property In Estate Planning

Advantages And Disadvantages Of Community Vs Separate Property In Estate Planning

My wife and I have an equal partnership – as she says, “What is mine is mine, and what is yours we’ll negotiate”. However, notwithstanding the definition of property in your household, Texas has its own laws defining ownership of property.

Texas is a community property state concerning marital property. This is important for tax reasons in addition to control and potential marital problems as described below. Determination of what is community property can be made by first determining what is separate property. The following is a list of what is considered separate property:

  1. Inherited property or gifted. If your parent dies and you are a beneficiary of that parent’s account’s, will, trust or you are a beneficiary by laws of intestacy, then the inherited property is separate property (although the income generated from separate property is community property under Texas law unless other agreed or gifted).
  2. Property owned prior to marriage. If you owned a home or other property that is in your name only prior to marriage, then the property remains your separate property if you divorce – even though community property funds were used to pay the mortgage (you would own the property, but your spouse would be entitled to reimbursement for his or her share of the community property funds used to reduce the mortgage).
  3. Property traceable. For example, if you owned some real estate prior to marriage and then you sold the property and bought another property with the proceeds, the newly acquired property would be considered separate property.
  4. Personal injury damages. If you were in a car accident during your marriage, the damages (other than damage for what you could earn) would be separate property.
  5. Agreement of spouses. Under Texas law, there can be a pre-nuptial or post-nuptial agreement on what is separate and what is community property, including the income derived from separate property. One misconception is if an account is in the name of one spouse only, it is always separate property. So, for example, if one spouse deposits all of his or her earnings in an individual account in that spouse’s name, it is still considered community property.

Biggest Advantage of Community Property – Double Step-Up in Basis:

Although one spouse can only transfer his or her community property interest at death, there is a full “step-up” in basis (the amount used to determine if there would possibly be capital gains tax) of the appreciation of the asset (which is unlike non-community property states) to the value of the property as of the date of death. Another “step-up” would occur (if the asset is retained by the surviving spouse) to the value as of the date of the last spouse to die.

Example 1: If the married couple purchased a homestead together for $200,000 and it was worth $500,000 at the date of death of the first spouse to die and $800,000 at the date of death of the second spouse, beneficiaries of the surviving spouse would only have to pay capital gains on appreciation over $800,000 as a result of the double step-up.

Example 2: Same facts as above except the surviving spouse sells the property for $750,000 and has lived in the property for 2 out of the last 5 years prior to selling the homestead (under the Internal Revenue Code, an individual who owns and lives in a homestead for 2 of the 5 years prior to date of sale will not have to pay capital gains tax on the first $250,000 of appreciation). Under this scenario, the surviving spouse would pay no capital gains tax due to the full step-up on the death of the first spouse and appreciation of $250,000 or less when the second spouse sold the property. If the couple had lived in a non-community property state, there would have been a tax since there would not have been a full step-up at the first spouse’s death. So, in the example above, instead of getting a full step-up at death of the first spouse to die, there would be only a step-up to that spouse’s ½ interest. In other words, instead of there being a step-up from $200,000 to $500,000, there would only be a step-up of ½ of the $300,000 appreciation. So, the step-up would only be to $350,000 (½ of $300,000 appreciation plus the original basis of $200,000). If the surviving spouse sold the property for $750,000 in a non-community property state, then he or she would have to had paid capital gains tax on $150,000 ($750,000 minus $350,000 basis as stepped up when first spouse died minus $250,000 of permitted appreciation without capital gains tax on homestead if the individual is single). Married couples are permitted appreciation of up to $500,000 on a homestead without capital gains tax if a homestead is sold while both are alive (exclusive of improvements and closing costs).

Example 3: If the first spouse to die owned the property as separate property, then there would be a step-up to value of the appreciated asset as of the date of his or her death. So, if the spouse that owned the homestead property and purchased it at $200,000 and it is worth $500,000 at his or her death and the surviving spouse sold it for $750,000, there would be no capital gains tax when the surviving spouse sold the homestead (since the basis would be stepped-up to $500,000 and there was not a gain in excess of $250,000). However, if the homestead was the separate property of the surviving spouse and the surviving spouse sold his or her separate property during his or her lifetime, then there would be a capital gains tax on the appreciation (since there was no step-up) minus up to $250,000 of appreciation permitted for a homestead if he or she lived in the home 2 of the 5 years prior to the sale. Thus, $750,000 (sales price) minus $250,000 (permitted appreciated without capital gains tax if homestead is owned by someone who is single) minus $200,000 basis (original purchase price assuming no improvements) equals capital gains tax on $300,000 of the appreciation.

As a result of the examples, it is often advantageous to have community property. So, if one spouse was concerned primarily about capital gains tax, then he or she could change separate property to community property by deliberately commingling separate property with community property. However, in Texas, a gift from one spouse to another might not necessarily convert separate property to community property as a result of tracing as mentioned above. It should be noted that under the Internal Revenue Code, the basis of acquired property (transformed from separate to community property) will not be fully stepped-up if acquired within one year of death of the donee spouse (there would only be a ½ step-up). If the donor spouse died first (within one year), the appreciated asset would get a full step-up in basis.

Disadvantage in Converging Separate Property to Community Property:

Although the tax advantage of community property should be considered in estate planning, there are several reasons to not do so, including:

  1. Divorce. Separate property would still be owned by the spouse who owned it prior to marriage. Community property would be split.
  2. Management and control of property. Each spouse may manage and control community property and dispose of his or her share of the community property. If one spouse had separate property, that spouse would have sole control and management of the property and could act alone in transfer of the property during life or at death (by will, trust, intestacy, etc.). If the property was community property, one spouse could not make a gift or transfer real estate without the consent of the other spouse. Furthermore, whether the property is community or separate could make a difference as to who inherits it and how much that beneficiary inherits.
  3. Step-down in basis. Separate property converted to community property could depreciate. Thus, there could be a full step-down if the value has depreciated as of the date of death of the donee spouse (which could be less than the original basis). So, conversion to community property should only be used on highly appreciated property.

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