As our society becomes increasingly mobile, property issues become more and more complex.
Joshua Rubenstein, of Katten Muchin Rosenman LLP, provided a comprehensive summary of the pressing concerns in this area in his presentation at the 52nd Annual Heckerling Institute on Estate Planning in Orlando, Florida.
Community Property in the U.S.
There are currently eight U.S. states that have pure community property regimes. In addition, Wisconsin has adopted the Uniform Marital Property Act, which is based upon community property principals, and Tennessee and Alaska allow for community property trusts. While these jurisdictions represent a minority of states, they hold a large share of the U.S. population. For instance, Texas and California, the largest community property states, together hold over 20 percent of the total U.S. population. Given the number of people who may at one time or another live in a community property jurisdiction, practitioners would be wise to consider and keep community property issues in mind when dealing with clients.
Most U.S. states recognize that community property brought into a common law, non-community property, jurisdiction when a married couple changes their domicile retains its community property characteristics. However, rules vary dramatically internationally from country to country with respect to which country’s laws regulate community property when a married couple changes their domicile.
On the other hand, when a married couple maintains their community property domicile but transfers community property to a common law jurisdiction, things become “squishy,” as the common law jurisdiction may, based on facts and circumstances, apply the community property law of the couple’s domicile or the common law of the property’s common law situs.
Income and Transfer Tax Considerations
With respect to the U.S. income taxation of community property, earned income from community property is taxed as the separate income of the spouse performing the services that generated the income, while passive investment income is taxably split between the spouses.
From a U.S. transfer tax standpoint, when an individual in a community property jurisdiction dies survived by a U.S. citizen spouse, only one-half of the couple’s community property is includable in the decedent’s estate, while the community property interests of both spouses receive a basis adjustment. If a married couple enters into an agreement to convert community property into separate property, care must be taken because if the division is not equal, a gift may result between the spouses, which may be problematic if the transferee spouse is a non U.S. citizen not eligible for the unlimited gift tax marital deduction.
Ways to Regulate Community Property
Married couples may choose to regulate their community property interests through various agreements, and consideration should be given therein to each spouse’s respective rights in their community property upon divorce and death. It is important to keep in mind the enforceability of these various agreements under foreign law.
Advantages and Disadvantages of Preserving Community Property
Preserving the characteristics of community property has several advantages and disadvantages.
As noted earlier, while only one-half of a married couple’s community property is includable in the estate of the first spouse to die, the entire community receives a basis adjustment, which can be advantageous if the property has appreciated in value through the date of death of the first spouse to die (conversely, this may be disadvantageous in the event the property has depreciated). Additionally, since only one-half of the community is includable in the estate of the first spouse to die, it becomes easier to take advantage of lower maximum tax brackets. Another benefit is the potential use of minority interest discounts, since each spouse owns an undivided one-half interest in the community property. Certain creditor protection aspects may also apply with respect to community property.
On the other hand, gifting community property may be more difficult since the consent of both spouses is needed in order to effectuate a gift. A GRAT or QPRT of community property by one spouse in favor of the other may also be difficult given Internal Revenue Code Section 2036 concerns without first severing community property interests. Additionally, the deduction for estate tax administration expenses, deductions and losses is only applicable with respect to the one-half of the community property includable in the estate of the first spouse to die and certain elections based upon the adjusted gross estate may be harder to achieve.
An overarching point is that practitioners should keep community property issues in mind when helping clients who may have property with community property aspects in today’s very mobile society.