When States Compete for Trust Business, Clients Win!

Community property is the law in nine states (Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, and Wisconsin) for property acquired by spouses during the marriage. While the laws differ somewhat between community property states, it generally means each spouse equally owns property acquired during the marriage (not through gift or inheritance) regardless of how the spouses title the asset. An example is the purchase of a home. In a community property state, if you purchase a house during the marriage and put only one spouse’s name on the deed, the other spouse is still the legal co-owner.

North Carolina is not a community property law state but is considered a separate property state. If a home is purchased in North Carolina and titled in only one spouse’s name, then the law does not automatically deem the house owned by the other spouse ((even though the non-owner spouse will have statutory marital rights). If the titled owner spouse wishes to sell the house, then the non-owner spouse must release marital rights to pass good title, but he or she is not a 50% owner under the separate property law of North Carolina.

While community property laws may affect divorce division of property and distribution of the property after death (each community property state has its own legal nuances so the affects will likely differ depending on the state), the we want to limit this blog’s focus to the basis of community property after death and the possible use of a community property trust. At the death of the first spouse to die in a community property state, community property gets a full step-up in income tax basis to either (i) the fair market value of the property at the date of the decedent’s death, or (ii) the alternate valuation date if validly elected for both sides of the community property at the death of the first spouse, even though the surviving spouse’s property is not included in the decedent’s gross estate for federal estate tax purposes. This means there is a full step-up in basis after each spouse’s death. On the other hand, at the death of the first spouse to die in a separate property state, the basis of the decedent’s assets (but not the decedent’s spouse’s assets) is adjusted to the fair market value of such assets at death (IRC section 1014(b)(1)). So, for example, if a couple jointly owns a piece of property in a separate property state only half of the property’s basis is stepped-up at the death of the first spouse.

What if the state where the decedent dies is a separate property state, is there any way to get community property status so at the death of the first spouse the basis of all community property, regardless of whether held by the decedent or the surviving spouse, receives a full step-up in basis? Fortunately, several separate property states (but not North Carolina) have enacted opt-in community property in which a married couple may elect to have some or all the property acquired during marriage become community property. The list of states is growing and now includes Alaska, Tennessee, South Dakota and Florida. This expansion creates a planning opportunity. The planning opportunity extends beyond just investments and homes as it allows for increased depreciation deductions for business and investment depreciable property by having a new basis.

Strauss Attorneys has assisted North Carolina clients with obtaining a full step-up in basis on elected-in community property using the Alaska statute, but because the IRS has not acquiesced to this technique there can be no absolute assurance given that it may not be challenged. The Alaska Community Property Act (effective May 23, 1998) allows non-residents (i.e., North Carolina and South Carolina residents) to use a community property trust. The non-residents need to follow certain requirements, and the more contacts the non-residents have with the state whose law they are electing, the better. One of the key requirements in Alaska is that at least one trustee must be an individual domiciled in Alaska, or an Alaska trust company or bank. The Alaska trustee must have certain powers that include maintaining records and arranging for the preparation of any income tax returns that must be filed by the trust.

Effective July 1, 2021, Florida threw its hat into the community property trust ring by enacting the Community Property Trust Act (CPTA). The Probate and Trust Tax Law Section of the Florida Bar worked hard on getting the new Community Property Trust law enacted and added some very attractive features to distinguish Florida’s version from other states’ elect-in statutes (such as allowing individuals to serve as trustees and making the trusts more asset protective).

The Florida Community Property Trust must:

• Expressly state that it is a community property trust.

• Name at least one qualified trustee, a natural person residing in Florida, or a company authorized to have Florida trust powers. (A married couple living in Florida can be their own trustees—a plus!)

• Be signed by both spouses in accordance with Florida law.

• Conspicuously declare a statutory warning of the legal consequences of signing the agreement at the beginning of the trust instrument. The language should closely mirror the statutory language and urge both spouses to seek independent advice regarding same.

Like Alaska, Florida allows non-Florida residents to elect-in to their community property laws, allows both revocable and irrevocable trusts, and provides that the surviving spouse may have the power to amend the trust with respect to his or her one-half of the property. Florida’s Community Property Trust Act further provides that creditors of one spouse can only reach that spouse’s one-half of the assets held in a Florida community property trust (which is not the case in Alaska, for example, but is the case in Tennessee).

How will the IRS treat Community Property Trusts? There is an older Supreme Court case (Commissioner v. Harman, 323 U.S. 44 (1994)) that addressed an Oklahoma elect-in statute for reporting of taxable income (not step-up in basis). Oklahoma did not have a mandatory community property system. According to the Supreme Court, Oklahoma did not have a community property system dictated by statute, as an incident of matrimony. Harman stated that the community property elect-in did not apply to the reporting of income by the spouses. Congress changed the law (IRC section 1014(b)(6)) after Harman, allowing full basis adjustment at the death of the first spouse to die. The proponents of the Alaska act statute (and the Florida statute) that the legislative history underlying Congress’s 1948 legislation does not reflect a distinction between consensual and mandatory community property systems. Therefore, they conclude that Congress intended the full-basis step-up to apply whether the community property system was elective or mandatory. We at Strauss Attorneys are aware of several audits in Alaska where the IRS did not object to the full step-up in basis at first death, but the issue remains for non-residents as there can be no guarantee that as more states allow full step-ups the IRS will not be concerned by the lack of revenue and raise an issue at audit—especially if the current proposal to force tax on appreciated assets at death is enacted.

We encourage those interested in Community Property Trusts to carefully evaluate whether “electing” to a community property system is advantageous to their particular situation understanding the risk that the IRS may try to disallow the full step-up. The initial analysis will focus on the potential income tax benefits regarding the couple’s specific situation. Remember, there can be a downward adjustment in basis if the value declines eliminating a built-in loss for a surviving spouse. But, if assets have appreciated and continue to be stable or appreciate further and capital gains rates are changed to be the same as ordinary income tax rates (as proposed) or changed to 28% (also proposed—and perhaps a more likely outcome), then the attraction of a Community Property Trust will increase.

Attorneys Andy Strauss and Brad Henry are licensed attorneys in North Carolina and Florida and can assist clients with planning opportunities that apply the laws of either of these states. Please contact reception at our Asheville office (828) 258-0994 or Hendersonville office (828) 696-1811 to schedule an appointment.