MARCH 24, 2014 VOLUME 21 NUMBER 12
Which is better? How should we take title to our house? How about our brokerage account?
These questions are really common in our practice. The answer is actually pretty straightforward, but we do need to lay a little groundwork.
Arizona is a community property state. That means that property held by a husband and/or wife is presumed to belong to them as a community. That presumption does not apply if the property existed before the marriage, or was received by a gift or inheritance. There are special rules for property you owned in a non-community property state before you moved here. It’s also possible for a married couple to enter into an agreement that changes the nature of community property, but those agreements are relatively rare.
Historically, there was one great disadvantage to community property ownership, and one great advantage. That is, there was one advantage and one disadvantage if you assume that the couple would never get divorced. If you have substantial separate property and are considering turning it into jointly-held property, is that advisable? That question is beyond our short essay today, and the answer depends on your comfort level with your spouse and marriage. We’re not particularly accomplished marital counselors, and we don’t have any facts for your personal situation.
But assuming you and your spouse live together more-or-less-happily until one of you dies, here are the competing considerations to holding property as community property:
Advantage: Income taxes. Upon the death of one spouse, property held as community property takes on a new “basis” for calculating future capital gains. If you have stock that you bought at $1,000 and that you now sell for $10,000 (congratulations!), you have “recognized” $9,000 of gain and will pay income taxes based on that amount. But if you held that property in joint tenancy with your late spouse, it got a step-up in basis to his or her date-of-death value; assuming the stock was worth $10,000 on that day, your income tax is only on $4,500 of the total gain. But if you had held that stock as community property with your late spouse, there would be no capital gains tax on the sale at all.
Disadvantage: Probate. Until 1995, community property could not pass automatically to the surviving spouse. That meant that a probate was often required to transfer the deceased spouse’s community property interest to the surviving spouse. Since no probate was required for property held in joint tenancy (the “right of survivorship” part of joint tenancy means the surviving joint tenant receives the property without having to go through the probate process), most married couples opted for joint tenancy rather than community property.
In 1995, the Arizona legislature made the disadvantage to community property disappear — they created a concept of “community property with right of survivorship.” That means a married couple can have it all: they can get the full stepped-up basis for income tax purposes, but avoid probate, on the first spouse’s death.
Does that mean that all property should be titled as community property with right of survivorship? Almost, but not quite. There are a handful of problems that occasionally crop up and have to be considered:
- Not every married couple intends to leave everything to one another. You can still get the full stepped-up income tax basis and leave your share of community property to someone else — your children from a prior marriage, perhaps, or another family member. In such a case it might make sense to hold the property as “community property” (with no right of survivorship) but have a will or trust to make provisions for each spouse’s share.
- The income tax benefit does not always appear. Note that the benefit is not a direct tax savings, but only a potential savings. If you get a full stepped-up basis on property that you then hold until your own death, you haven’t really saved any tax money. But the community property benefit just might give you flexibility — you can decide to sell property after your spouse’s death on the basis of good investment advice, rather than the tax effect.
- The option only applies (this is obvious, but we need to say it) to married couples. “Community property” is not available to anyone else. Is it available to same-sex married couples? Yes.
- The benefit may not even be necessary for some assets. No growth in your brokerage account? No benefit. You invest only in municipal bonds and certificates of deposit? Minimal to no benefit. But here’s the big one: most people’s biggest growth asset is their home — and there’s already a substantial ($250,000) exemption from capital gains taxes for a single (widowed) person selling their home.
- Have you already established a trust as part of your estate plan? You may not need to go through the analysis, since the practical effect of your plan may be the same as the benefit of community property with right of survivorship — or better. Ask your estate planning attorney to review this with you.
- There are sometimes costs to making the change. For real estate, you will need someone to prepare a deed (you can probably get it right on your own, but it makes sense to hire a professional). In addition, there are modest costs to record the new deed.
- This only applies to Arizona property. No problem with your brokerage or bank account — they are Arizona property if you live here. Your vacation cottage in Montana, or your Mexican condo held in a land trust, are a different matter. But if your vacation cottage is in Alaska, or California, Idaho, Nevada or Wisconsin, you might be able to do something similar. Ask a local lawyer about the possibility.
- We need to reiterate: if you have separate property and transfer it to community property with right of survivorship to take advantage of income tax benefits, you may have made a gift of half of your separate property to your spouse. Be careful, and make sure you know what you’re doing.
What’s your bottom line? Should you change everything you own from joint tenancy with right of survivorship to community property with right of survivorship? Maybe, but your home is the least urgent thing to tackle. Your brokerage account? Absolutely. Your summer cottage in another state? Check with your lawyer and ask her (or him) to find out whether the other state has community property with right of survivorship.
Note that none of this really helps you deal with retirement accounts, IRAs, 401(k) accounts, separate property you brought from another state or your complex estate planning intentions. For those, you really need to talk with your lawyer. Also, please be clear: we do not know the correct answer if you live in a state other than Arizona — talk to your local lawyer about that.