As remote and hybrid work arrangements become more commonplace, the focus on attracting new residents has intensified for many state legislatures. To entice individuals and families to call their state home, some lawmakers have adopted an innovative strategy—allowing married couples moving from community property states to opt for community property treatment of their assets. This seemingly subtle change in legislation can, in fact, hold the key to significant income tax benefits, making it an intriguing development for financial advisors and estate planners.
Traditionally, community property law has been the default in just nine U.S. states. In these states, the law presumes that both spouses share an undivided interest in all assets earned or acquired during the marriage, regardless of who earned them or whose name appears as the owner of the asset. For example, John and Mary are married and living in California. John works at a startup and receives stock options from his start up in his own name. Even though Mary’s name is not associated with the options, California law presumes she has a right to half of those options if they were to divorce or John were to die.
A growing number of states are now introducing elective CP laws. This means that residents of states that do not traditionally adhere to community property principles can choose to override the default rules for some or all the couple’s jointly owned assets.
Advisors can yield meaningful capital gains tax savings for their clients by suggesting a conversion to community property. While they need not become certified tax experts (they have their CPA partners for that), it’s essential advisors gain a solid grasp of how these laws impact the financial plans they offer their clients. Advisors can start by delving into the fundamental tax principles underlying these rules: tax basis, capital gains and the basis step-up.
Tax Basis and Capital Gains
Generally, we can think of tax basis as the amount of money it took to acquire a given asset, and the capital gain as the “profit” made when the asset is sold. For example, if a person bought a house 20 years ago for $200,000 (without renovations to increase the basis or depreciation to decrease the basis), selling it for $600,000 today would result in $400,000 of capital gains.
A higher basis results in lower capital gains, and subsequently, a lower tax burden. The tax rules allow the basis of an asset to be changed (either increased or decreased), and one such instance is upon the death of the owner. Typically, when the owner of an asset passes away and the property is distributed to a new owner, the tax rules allow the new owner to renew the basis to the fair market value of the asset at the time the previous owner died.
To look at this another way, consider the homeowner in the previous example. He didn't sell the house but retained it until death, when it was inherited by his child. Instead of the basis remaining at the purchase price of $200,000, it is adjusted to the fair market value of $600,000 in the hands of the child.
This illustrates a significant tax advantage for the heir. The house’s basis is “stepped up” to fair market value, substantially diminishing the capital gain and the related tax on the house. Should the child decide to sell the parents’ house soon thereafter, the child may not incur any capital gains taxes on the sale at all.
The Double Basis Step-Up
The basis step-up provides a substantial income tax advantage. But less well known is that in community property states married couples can potentially receive what's termed a double basis step-up, resulting in an even greater tax benefit.
First, let's clarify how this process functions in the absence of CP. When a married couple resides in a state where CP is not the default, and they acquire an asset during their marriage, the way they title the asset dictates the portion attributed to each spouse. In the event of the first spouse's passing, only the property attributed to that spouse undergoes a basis step-up. For instance, if the couple jointly owns an asset, such as in "joint tenancy," each spouse is ascribed half of the asset's value at the time of the first spouse's death. Consequently, only half of that asset qualifies for the basis step-up.
When a married couple does live in a CP state and acquires an asset during their marriage, both partners share an "undivided interest" in that asset for as long as they're married. Community property then delivers a doubled income tax advantage at the death of the first spouse: a basis-step up over the entire asset, if it was characterized as CP. This outcome of CP characterization is referred to as the “double basis step-up.” It effectively reduces the capital gains tax that beneficiaries, including the surviving spouse, will incur when they eventually sell the asset.
Example: A Married Couple Living in Florida (Non-CP) vs California (CP)
Let’s illustrate the above with two examples. A married couple jointly acquires their Florida home for $200,000 as joint tenants (non-CP). Now, fast forward to the unfortunate event of the first spouse's passing, at which point the house's value has appreciated to $600,000.
The surviving spouse sells the house soon thereafter for $600,000 and files the income tax returns. The spouse calculates a basis of $400,000 for the house. Here's the breakdown: half of the home receives a step-up to $300,000 (reflecting the fair market value over the deceased spouse’s half), while the surviving spouse's half of the home retains its original basis of $100,000. The surviving spouse thus recognizes $200,000 of capital gains tax at the time of sale.
Now suppose the same married couple instead lived in California, a CP state. The surviving spouse calculates a basis of $600,000 at the time of sale. This occurs because the entire home receives a step-up to fair market value. In this situation, where the basis matches the $600,000 market value, the surviving spouse residing in California faces no capital gains tax liability. This is the power of the double basis step-up.
Future of the Trend
A full-scale change in legal regime from non-CP to CP by states seems improbable considering the depth of legal modifications needed. However, non-CP states have recognized the growing demand among individuals relocating from CP states who wish to keep CP characterization, as well as from their own residents who want this income tax advantage. Several states, including Florida, now provide married couples with the option to elect CP treatment for their assets.
Characterizing assets as CP is not without its drawbacks. First, your clients may be creating a presumption that each CP asset is to be divided equally during marriage and upon divorce, whereas traditionally, non-CP law would favor an equitable division that isn’t necessarily a split down the middle of the asset. The most famous example of this is the divorce of Jeff Bezos and Mackenzie Scott. They lived in Washington, a CP state, so the law presumed that their Amazon stock should be divided 50-50 upon divorce.
The second is that certain forms of title for property carry creditor protection features, like tenancy by the entirety, which will be lost by converting the asset into CP. And lastly, if it’s important for one member in the couple to control the disposition of a particular asset, characterizing it as CP even if in the sole name of that person would cede the disposition over half the asset to the spouse.
This rise of ‘opt-in’ CP underscores the need for CPAs and financial planners to understand the implications of electing CP treatment. Equally vital is ensuring clients understand how this choice shapes their financial and estate plans. To stay ahead in this changing landscape, forward-thinking advisors must closely monitor evolving state laws. They should be poised to meet the rising demand for estate planning that's not only well-informed but tailored to the unique nuances of each state. By doing so, advisors can help to secure their clients' financial futures with confidence.
Anne Rhodes is the Chief Legal Officer at wealth.com, a next-gen estate planning platform
