Deciding Whether to Convert Separate Property to Community Property

Jan 17, 2019
Estate Planning

In estate planning involving spouses there may be issues surrounding how to deal with separate property acquired prior to marriage or as a result of inheritance.

As part of your estate planning consultations with your attorney, you may be asked whether you wish any particular property or financial assets you currently consider to be your sole and separate property to remain your sole and separate property once transferred to your trust, or whether you wish to convert or confirm that such assets are intended to be the community property of both spouses.  There are pros and cons to this decision and what follows is a discussion of the most common questions surrounding this issue.

In Community Property States such as California, Arizona, Texas, Nevada, Idaho, Louisiana, New Mexico, Washington or Wisconsin, Community Property Law concerns the distribution of property acquired by a couple during marriage in the event of the end of the marriage, whether by divorce or death of one of the parties. In community property states all property (both real, personal and financial) accumulated by a husband and wife during their marriage becomes joint property even if it was originally acquired in the name of only one partner, unless the spouses enter into some form of formalized agreement concerning their separate and joint ownership of property.

Important Definitions:

Community property is ordinarily defined as everything the couple owns that is acquired during the marriage with the exception of separate property owned by either of them individually.

Separate property is that property that each individual brings into the marriage, in addition to anything that either spouse acquires by inheritance during the marriage.

Quasi Community property is property which is initially the separate property of one spouse but through specific action or inaction can become partially the property of the other spouse under operation of law, such as through commingling.  Quasi Community property is any property owned between spouses or where a spouse acquires an equitable interest which is other than 50/50 ownership.  Examples include combining separate property assets with community property assets; using earnings from employment to pay housing expenses on otherwise separate property such as mortgage payments, property taxes, insurance; failing to compensate a non owner spouse for performing services contributing to the economic utility of separate property, such as having a non owner spouse preview and screen possible tenants for rental property or conducting repairs on same.

Generally, four types of property acquired after marriage amount to community property: earnings, damages obtained from a personal injury suit, damages awarded in an industrial accident action, and rents and profits from separate property.

Benefits generally associated with Community Property

Step Up In Basis

In general, community property assets such as real estate or other appreciating assets such as securities or even businesses will receive a full “Step Up In Basis” on the death of either spouse. Assets owned by only one spouse or held as joint tenants receive only a partial step in basis representing only the decedent's ownership interest. Step Up In Basis is the general rule applied to appreciating assets in that the beneficiary's (or recipient of the assets) basis equals the fair market value of the property at the time the decedent dies. For capital gains tax purposes, owning appreciating assets between spouses as Community Property is generally much more tax efficient. You should speak with a qualified tax advisor for more specific information on your situation.

What about giving away appreciating assets during your lifetime?

Example, if you give a home to a Beneficiary before your death, the Beneficiary would receive a carryover basis, which would be equal to the transferor's adjusted basis in the home, otherwise known as your original cost for the property plus certain capital additions made during the course of ownership. Often this results in a ‘built in' capital gain that could largely be avoided if the asset is inherited rather than gifted during your lifetime.

Estate Tax Planning

In marital estates which may be subject to Estate Taxes, a benefit may be gained by dividing the value of community property assets held in certain types of Living Trusts to maximize the amount of one's estate that may pass to beneficiaries free from any estate taxes. Again, you should seek the advice of your estate planning and/or a qualified tax advisor as it may relate to your situation.

How Do You Convert Separate Property to Community Property?

Usually, converting separate property to community property involves adding your spouse to the title of your bona fide separately owned property or engaging in activities as illustrated above which tend to allow your spouse to acquire a material interest in such property (quasi-community property).

General Drawbacks to Converting Separate Property to Community Property.

The most common drawbacks to converting separate property to community property is that you may not be able to fully control the ultimate disposition of the property without the consent of your spouse, and in the case of divorce, your spouse will likely be awarded half of the property, or more or less, depending on the circumstances and judicial decisions.

Benefits to Owning Separate Property.

Separate property may be managed, disposed of, or bequeathed through inheritance at the sole discretion of the owner of the separate property, without requiring the consent of the non-owner spouse.

Drawbacks to Owning Separate Property.

  • In the event the spouse owning separate property dies first, unless properly structured through an effective estate plan, your spouse may unintentionally be deprived of the use of the separate property or the property itself, if that was your intent.
  • You may lose significant tax benefits you might otherwise be entitled to in the areas of capital gains taxes or estate taxes.
  • Unless you have a formalized agreement regarding the treatment of separate vs community property, such as may be created as part of your estate plan, or by entering into a pre-nuptial or post-nuptial agreement, it is often difficult to ensure that there is no prospective commingling which may have the effect of converting your separate property to community or quasi-community property.

How Can You Keep Your Separate Property Separate?

In general, your separate property acquired prior to marriage or received through inheritance can maintain its separate property status if:

  • The property is not co-mingled with community property assets
  • The non-owner spouse is not added to title
  • A pre-nuptial or post-nuptial agreement is entered into
  • Property is held in trust as the separate property of only one spouse (usually combined with executing a separate property agreement addendum to the trust and titling the property “In Trust as the sole and separate property of husband or wife”)

Note: These scenarios are not exhaustive and you should seek professional guidance from your Estate Planning attorney as it relates to your particular circumstances.

In an estate planning setting, each spouse generally can designate their own beneficiaries to their share of Community or Quasi-Community Property. The exception is owning property vested as Husband and Wife as Community Property with Right of Survivorship. In this case, in states where applicable, the surviving spouse is considered the sole owner of such property.