Where you live matters for estate planning, since laws regarding estate planning are state specific. The same is true for taxes, especially for married couples, says a recent article “How Community Property Trusts Can Benefit Married Couples” from Kiplinger.
There are two different types of basic ownership law for married couples: common law and community property law. Variances can be found across states, but some general rules apply to all. If a state is not a community property state, it’s a common-law state.
Community property states have a tax advantage for assets when one spouse dies. But if you live in a common-law state, don’t worry: several states have now passed statutes allowing married couples living in a common-law state to establish a community property trust with a qualified trustee. They can gain a step-up in cost basis at each death, which previously was not allowed in common-law states.
First, let’s explain what community property means. Each member of the married couple owns one half of all the property of the couple, with full rights of ownership. All property acquired during a marriage is usually community property, with the exception of property from an inheritance or received as a gift. However, laws vary in the community property states regarding some ownership matters. For example, a spouse can identify some property as community property without the consent of the other spouse.
Under federal law, all community property (which includes both the decedent’s one-half interest in the community property and the surviving spouse’s one-half interest in the community property) gets a new basis at the death of the first spouse equal to its fair market value. The cost basis is stepped up, and assets can be sold without recognizing a capital gain.
Property in the name of the surviving spouse can receive a second step-up in basis. However, there’s no second step-up for assets placed into irrevocable trusts before the second death. This includes a trust set up to shelter assets under the lifetime estate tax exemption or to qualify assets for the unlimited marital deduction. This is often called “A-B” trust planning.
Under common law, married couples own assets together or individually. When the first spouse dies, assets in the decedent spouse’s name or in the name of a revocable trust are stepped-up. Assets owned jointly at death receive a step-up in basis on only half of the property. Assets in the surviving spouse’s name only are not stepped-up. However, when the surviving spouse dies, assets held in their name get another step-up in basis.
To date, five common-law states have passed community property trust statutes to empower a married couple to convert common-law property into community property. They include Alaska, Florida, Kentucky, South Dakota and Tennessee.
The community property trust allows married couples living in the resident state and others living in common-law states to obtain a stepped-up basis for all assets they own at the first death. Those who live in common-law states not permitting this trust solution can still execute a community property trust in a community property state. However, they will first need to appoint a qualified trustee in the state.
For this to work, the trusts need to be prepared properly by an experienced estate planning attorney, who will also be able to advise the couple whether there are any other means of achieving these and other tax planning goals.
Reference: Kiplinger (Sep. 18, 2022) “How Community Property Trusts Can Benefit Married Couples”