Separate Property And Community Property
Proper characterization of a married couple’s property as community property or separate property can be critical to the success of that couple’s estate plan. Under California law, separate property is property owned prior to marriage, or received during the marriage by gift or inheritance. Community property consists of other property acquired during marriage while domiciled in California. Community property assets are generally acquired with the earnings from personal services of either spouse. Examples of community property are:
- Salary or bonus earned for work done by either spouse during marriage
- A residence (or any asset) purchased with salary or bonus
- An employee’s retirement plan account with contributions made during marriage
- Stock options earned during marriage
- A business funded with community property and increasing in value because of the efforts of either spouse
On the other hand, stock (or any asset) owned prior to marriage, or inherited from a parent, prior spouse (or any person) during marriage is separate property.
A third category of property is quasi-community property, which is property acquired by either spouse while domiciled outside of California, but which would have been community property if the acquiring spouse had been domiciled in California at the time of acquisition. For example, if a couple moves to California, bringing funds earned during marriage by the husband in a separate property state, those funds are the husband’s quasi-community property. In the event of divorce in California, quasi-community property is treated like community property. At death of the acquiring spouse in California, that spouse’s quasi-community property is treated like community property, but is taxed for purposes of the federal estate and income tax as the separate property of the acquiring spouse. More detail regarding quasi-community property is outside the scope of this memorandum. If you have questions, we would be happy to discuss them with you.
Income From An Asset
The income generated by a separate property asset, such dividends from a separate property stock or interest from a separate property bank account, is separate property. If the separate property asset is sold and the proceeds invested in a new asset, that asset is separate property. Conversely, the income generated by a community property asset is community property, and if the community property asset is sold and the proceeds invested in a new asset, that asset is community property.
Community and separate funds may be commingled in one asset. The rights of the parties in that asset will depend on a variety of factors, including how title is held, the binding agreement of the parties, and whether the question of ownership arises during marriage, at divorce or on death.
Whereas each spouse has a one-half interest in community property, one spouse has no interest in the other spouse’s separate property. This distinction, and the character of property as community or separate, can be significant in a variety of situations. One important area is the rights of creditors. With certain exceptions, creditors of one spouse can reach the debtor spouse’s separate property and all the community property, but not the nondebtor spouse’s separate property. The distinction between community property and separate property is particularly important at the time of marital dissolution (divorce) or death.
At the time of divorce, each party is entitled to one-half of community property and all of his or her separate property. Determining what is community and what is separate can be difficult and the subject of dispute, particularly where community and separate property funds are commingled and assets contain some of each. California law provides certain rules or guidelines for determining each party’s rights, such as Family Code Section 2640, providing that where there is a separate property contribution to the acquisition of a community property asset, the contributing party is entitled to reimbursement of that contribution on divorce.
Death Of A Spouse: Estate And Income Tax Ramifications
At death of a spouse, a determination must be made with respect to each asset as to whether it is community property or the separate property of one of the spouses. This determination is required for tax purposes. The deceased spouse’s separate property and one-half of the community property are subject to federal estate tax, whereas the surviving spouse’s separate property and one-half of the community property are not. (With proper planning, there may not actually be a tax because of the exemptions and deductions available.) Also, the deceased spouse’s separate property and all of the community property receive a step-up or step-down in basis to the fair market value at the date of death, whereas the surviving spouse’s separate property does not. For appreciated property, a step-up in basis can be an important benefit that results in income tax savings when the property is subsequently sold. (These basis rules will change substantially for deaths in 2010 and later, if estate tax repeal actually goes into effect and is made permanent.)
Death Of A Spouse: Property Distribution
Just as important as the tax ramifications at death is the fact that property characterization determines how and to whom the property is distributed. Each spouse has the right to determine who receives all of his or her separate property and one-half of the community property. If a husband and wife have simple wills leaving their entire estate to each other, or if they both die, to their common children, then, although determination of property characterization must be made on death, it does not affect the distribution. If, on the other hand, the deceased spouse leaves assets to children of a prior marriage, or to any beneficiaries other than the surviving spouse, or to a trust for the surviving spouse, property characterization is significant because that distribution must be taken from the deceased spouse’s separate property or one-half community property interests, not from the surviving spouse’s interests.
One type of estate plan in which property characterization is significant is the typical revocable living trust which holds title to the assets of Husband and Wife, and then on the first death divides into two trusts, or depending on the estate plan, into three trusts. Consider the following example: Husband and Wife have a revocable trust. On Husband’s death, the trust is divided into two trusts: The irrevocable Exemption Trust, which contains Husband’s one-half of the community property and all of his separate property, is available for the benefit of Wife for her lifetime, and then on her death passes to children. The Survivor’s Trust, which contains surviving Wife’s one-half of the community property and all of her separate property, continues to be owned by her as her revocable trust, and on her death passes to children. In order for assets to be allocated between the two trusts, the determination must be made for each asset as to whether it is community property, Husband’s separate property, or Wife’s separate property. The property characterization and allocation between trusts can have significant importance. Husband’s Exemption Trust must pass to the children on Wife’s death, but Wife has the right to change the terms of the Survivor’s Trust to leave it on her death to other beneficiaries, such as a new husband. If Husband and Wife have children of prior marriages, so that the ultimate beneficiaries of the Exemption Trust are Husband’s children and the ultimate beneficiaries of the Survivor’s Trust are Wife’s children, the importance of the property characterization increases, as does the likelihood of dispute about it by the beneficiaries. Determining the property characterization at death can be difficult, particularly if separate property and community property have been commingled. (The above mentioned right of reimbursement for a separate property contribution to community property applicable on divorce does not apply on death. In some situations on death, however, there is tracing of property contributions.) It is necessary to look at how title to the asset is held, the source of funds of purchase, and any property agreement between the spouses characterizing property as separate or community.
Clarifying Property Characterizations
If the property characterization is not clear, or does not reflect the spouses’ intentions, what problems can arise? Here are several examples:
- Either during the marriage or on Husband’s death, Husband’s creditors seek to attach property that was originally Wife’s separate property, claiming that it is community property.
- Husband and Wife divorce, and arguments arise between them as to the community or separate nature of their commingled property.
- Husband dies, with a joint revocable trust estate plan, as discussed above. Argument arises between surviving Wife and Husband’s children of a prior marriage regarding property characterization. Husband’s children are trying to maximize the assets that pass directly to them, or to the Exemption Trust that will pass to them on Wife’s death. Wife is trying to maximize the assets that will pass to her Survivor’s Trust, then on to her children on her death.
- Both spouses die, each with children of a prior marriage, and dispute as to property characterization arises between the two families.
- The Internal Revenue Service argues that an asset is the separate property of the surviving spouse, which will not receive a step-up in income tax basis on the death of the deceased spouse, rather than community property, which will receive a full step up in basis.
These problems can be avoided if property can clearly be determined as either community property or separate property. How is this accomplished?
Firstly, the character of the property can be indicated on title. A spouse’s separate property should be titled in his or her name, and community property should be titled in both names. Ideally, title will reflect the property’s character, for example, on real estate, “John Smith and Mary Smith, husband and wife, as community property”, or “John Smith, a married man, as his sole and separate property.” If assets are held in a revocable trust, the title will be in the name of the trust: “John Smith and Mary Smith, Trustees of The Smith Trust dated September 4, 2004.” If clarification is needed, “as community property”, or “as John’s separate property” can be added. Under federal law, retirement plan accounts must be held in the name of the employee spouse; this does not affect the community interest of the other spouse.
Secondly, if separate property and community property assets are to retain their character as such, they should not be commingled. Commingling can involve, for example, taking husband’s salary (community property) and investing it in Husband’s separate property brokerage account, or taking funds from Husband’s separate property brokerage account and using them to pay the mortgage on the community property home. Instead, the mortgage on the community property home should be paid with salary or other community property. A community property bank or brokerage account should contain only community property funds, and a separate property bank or brokerage account should contain only separate property funds.
Thirdly, the spouses can enter into a valid and binding agreement regarding the community or separate property nature of their assets. Such an agreement could be important in many situations, including the following:
- One spouse has separate property which he or she wishes to protect in the event of a divorce.
- One spouse has separate property which he or she wishes to protect from the creditors of the other spouse.
- The spouses wish to transmute the character of certain property, that is, change community property to separate, or vice versa, for tax or other reasons.
- The couple has a blended family, i.e., one or both spouses has children of a prior marriage, or otherwise has different beneficiaries who will inherit on death.
The drafting of such a property agreement is not a casual matter. While there may not be a current conflict of opinions between spouses, there may be real conflicts of interest between them in the legal sense. The rights and benefits of each spouse, during marriage, on divorce, or on death, can vary significantly depending on the property characterization. In addition, the spouses may have different beneficiaries (such as children), whose benefits at death will differ depending on the property characterization. The agreement will be binding on divorce, as well as death. Agreeing, for example that an asset is community property rather than separate property may be advantageous on death, but not so on divorce. Because of these conflicts of interest, and in accordance with the current rules governing legal ethics, we strongly advise that in the preparation of a property agreement, each spouse be represented by separate counsel. This helps ensure that each spouse receives the advice needed to make a good decision, and also that the agreement is binding.
A husband and wife can perform a service for themselves, the survivor of them on death, and children or other beneficiaries by establishing property characterizations that are clear and easily determined. These are complex issues and not ones that anyone likes to address, but they are issues best resolved by the parties themselves before problems arise, rather than later, by others or the courts. This memorandum is not intended to be exhaustive, but rather to raise important issues for your consideration. If you have questions or concerns, we would be happy to discuss them with you.