Community Property Trusts

Take-Away: A Bill will soon be introduced in Michigan’s legislature (if not already) to permit spouses to classify the assets held in their joint trust as community property. The advantage to spouses who own community property is that there will be a full (100%) income tax basis adjustment (a hoped for ‘stepped-up’ basis) on the death of one spouse, as opposed to the normal 50% income tax basis adjustment which is the rule for assets that are jointly owned by spouses in common law jurisdictions like Michigan. This Bill is yet another reflection of the paradigm shift in estate planning away from saving estate taxes to saving income taxes on the death of a client.

Background: The Michigan Optional Community Property Statute [remember, it is only a proposed Bill at this time] exploits an income tax provision in the federal income tax laws which is conferred only on spouses who reside in the 9 community property jurisdictions: California, Texas, Arizona, Nevada Idaho, New Mexico, Washington, Louisiana, and Wisconsin. The income tax benefit is conferred on the surviving spouse. The income tax savings result when the surviving spouse sells property that had previously been held by the spouses as community property. IRC 1014(b)(6).

Common Law Jurisdictions: In a common law jurisdiction, like Michigan, if the spouses own property jointly, or as tenants-by-the-entireties, and one spouse dies, there is only a 50% adjustment, usually called a ‘step-up,’ in the asset’s income tax basis. If the surviving spouse later sells the previous jointly owned asset, they will probably recognize some capital gain due to the limited basis adjustment on the death of one spouse. IRC Sections 2040(b) and 1014 create this limited basis adjustment on the death of one spouse.
Civil Law Jurisdictions: In contrast, if the spouses reside in a community property jurisdiction, there is a 100% (not a 50%) adjustment to the assets’ tax basis owned by the spouses, so that if a surviving spouse in a community property jurisdiction sells the asset shortly after their spouse’s death, the survivor will sell the asset with an income tax basis equal to the asset’s fair market value on the death of the one spouse, resulting in no capital gain recognition.

History Lesson: The reasoning behind the 100% basis adjustment (presumably a ‘step-up’) in community property permitted under IRC 1014(b)(6) can be traced back to the time that this tax rule was enacted. In the 1940’s most marital property was earned by the husband. Thus, in common law jurisdictions most of a married couple’s assets might have legally been classified as the husband’s separate property. If the husband died first, presumably all of the husband’s separate property would receive a basis adjustment, or ‘step-up.’ In contrast, in community property jurisdiction where the husband’s earnings are treated as community property, only one-half of the married couple’s assets would receive a ‘step-up’ in income tax basis on the husband’s death, leading to unequal income tax treatment of married citizens in common law and community property jurisdictions. Consequently, IRC 1014(b)(6) was enacted to address that perceived inequality giving a full 100% income tax basis adjustment to all assets owned by a husband and wife in a community property jurisdiction.

Example:

Assume that a Husband and Wife who live in Michigan purchased land years ago for $100,000. Over the years the land has appreciated in value to now be worth $500,000. Consequently there is a gain of $400,000 in the land. Husband dies. Wife wants to immediately sell the land, and she sells it for $500,000. The cost basis for Wife is equal to one-half of the initial purchase price, or $50,000, plus one-half of the $500,000 fair market value of the land on Husband’s death, or $250,000, for an aggregate of $300,000 as Wife’s cost basis at the time of the sale of the land. Wife will pay a capital gains tax on $200,000 [$500,000 gross receipt less her adjusted cost basis of $300,000= $200,000 gain recognized.]
If Husband and Wife lived in California, and the facts were the same, Wife would pay no capital gains taxes on her sale of the land for $500,000; there would be no capital gain recognized on her sale of the land because her adjusted income tax basis is equal to the asset’s date of Husband’s death value, which is authorized by IRC 1014(b)(6.)

Advantages: If this Bill becomes the law in Michigan and spouses are able to intentionally classify the assets held in their joint trust as community property, advantages can arise from that mutual decision:

Taxes: As noted, if Wife wants to sell the trust asset after Husband’s death, e.g. think of his 500 acre deer-hunt camp in the UP, or his fishing cabin on the Au Sable River, she can liquidate the non-income producing asset without having to pay any capital gains taxes and she can reinvest all of the sales proceeds in income producing assets for her future support;
Depreciation: If the asset owned by Husband Wife is used for business purposes and it is subject to depreciation deductions, like an office building, Wife will have a new (higher) income tax basis on which to claim depreciation deductions associated with that asset on her future income tax returns to reduce her taxable income;
Proving Basis: Often when assets were purchased decades earlier it is a challenge for the surviving spouse to find documentation to prove the initial purchase price paid for the jointly owned asset. There is no need to dig up old records to prove the earlier purchase price paid as a part of the asset’s income tax basis; the community property asset will automatically receive a full (100%) income tax basis adjustment on one spouse’s death without the need to substantiate that increase in tax basis.

Disadvantages: There are a couple of disadvantages associated with the spouses’ voluntary decision to classify their assets as community property in their joint trust. Those disadvantages include the following:

Creditors: The spouses will lose creditor protection if they convert their entireties owned property to community property. [Note: There is also a proposed Bill floating around Lansing that would permit spouses to classify their assets held in their joint trust as entireties property, to ensure entireties creditor protection for those assets titled in their names as cotrustees of their joint trust, from claims held by creditors against only one spouse. I have not heard, yet anyway, of the possibility of combining both classifications into one joint trust where the property would retain its entireties creditor protection, and also be treated as community property to achieve a full income tax basis adjustment on the death of one spouse-cotrustee.]
Divorce: Community property is treated for all purposes, including divorce, as being owned one-half by each spouse. Restated, Michigan recognizes the separate property that each spouse brings to a marriage and with several exceptions, a divorce judge is supposed to restore that separate property to the spouse who brought that asset into the marriage, e.g. assets that are inherited or gifted to one spouse, or assets owned by an individual prior to his or her marriage. The ability to claim that a spouse’s separate property should be restored to them in the event of a future divorce will be lost if the spouses agree to classify all property titled in the name of their joint trust as their community property. [Note: Maybe this restoration right could be the basis of a provision in a premarital agreement, but I would not hold my breath as to the enforceability of such a premarital agreement provision in light of how unreceptive Michigan courts are these days to premarital agreements in a divorce setting.]

Community Property Tracing: It should be mentioned in passing that Michigan has a statute that recognizes the source of community property that spouses bring into the state that is enforced on the death of one spouse. Assume a married couple amass a large estate while living in Texas, but then they retire to Michigan bringing their community property assets with them. One spouse dies while a resident of Michigan. The survivor can still claim the full (100%) income tax basis ‘step-up’ of those community property assets, even though the survivor continues to be a Michigan resident. But the survivor will have to prove the (i) community property origins of those assets, i.e. they were accumulated in Texas; and (ii) the spouses’ intention to retain the community property nature of those assets even after they moved to Michigan, a common law jurisdiction. This means that those spouses who move to Michigan from a community property state need to segregate and treat separately those community property-origined assets from their Michigan common law accumulated assets, and they should sign a community property agreement that manifests their mutual intent to retain the community property character of those segregated assets, despite their choice to live in a common law jurisdiction and enjoy some of the perceived benefits of a common law jurisdiction. [See Uniform Disposition of Community Property at Death Act, MCL 567.261 et. seq., and Rev. Ruling 87-98, 1987-2 C.B. 206 where the IRS found the effect of a community property agreement to be binding on the Service.]

Conclusion: Obviously a substantial income tax benefit can be achieved if assets are classified as community property. Spouses who have never lived in a community property jurisdiction have historically been unable to classify, by agreement, a full income tax basis step-up on the death of one spouse if the assets were never accumulated in a community property jurisdiction. If the Michigan Optional Community Property Statute becomes the law of this state, then a simple agreement by the spouses to classify their assets held in the joint trust as community property will dispense with the need to show where the assets were originally accumulated and will achieve the same income tax basis adjustment that spouses in community property jurisdictions currently enjoy on the death of one. In short, it is important to identify community property assets our clients own, even if they are now Michigan residents.