Estate Planning for California Community Property
When we meet with married couples, one of the many important topics we discuss is estate planning for California community property and separate property. As many of us know, California, unlike most states, is considered a community property state. Most people assume, incorrectly, if you are married, then all of your property is community property.
What is Community Property?
California law defines community property as all property acquired by a California domiciliary during marriage that is not specified by statute to be separate property. Family Code Section 760
What is Separate Property?
California law defines separate property as all property owned before marriage and all property acquired during marriage that is acquired by gift or inheritance. Family Code Section 770(a)(1)-(2).
Changing Character of Property
Married couples may change the characterization of property during marriage from community property to separate property of each spouse, community property to separate property of one spouse, or from separate property to community property. Family Code § 850. The process of changing the character of property is often called “transmutation.” A transmutation of real or personal property is not valid unless made in writing and agreed to by the spouse whose interest in the property is adversely affected. Family Code § 852.
How Community Property and Separate Property are Treated Differently
The distinction between community property and separate property has a huge impact on the distribution of property at death, division upon divorce and tax basis for income tax purposes. Let’s look at how each type of property is treated in different situations.
Generally, if a married couple gets divorced, the community property is split equally between spouses. The owner of separate property generally receives 100% of any separate property at the time of divorce.
At death, without any estate planning, the community property assets would end up in probate, but eventually distributed to the surviving spouse, after fees and costs. A deceased spouse’s separate property is a bit more complex. Depending on the family situation, the surviving spouse is entitled to 50% or more of the separate property.
As you can see, the distinction between separate property and community property has a huge impact on the rights of the owner, spouse and family members.
From an income tax perspective, community property receives a “double step-up in basis at the death of either spouse. Separate property only receives a step up in basis on the deceased spouse’s ownership in property. This is much easier to understand with an example.
Example of Taxes with Separate Property: John and Jane are married and purchased their first home as husband and wife, as joint tenants for $500,000 in 1995. Most married couples own their home as joint tenants (due to the poor advice by most realtors). Joint tenancy is considered separate property of each joint tenant. Therefore, John and Jane each have a $250,000 undivided separate property interest in the house. In 2016, John passes away. At the time of John’s death, the house is worth $1,500,000. Jane decides to sell the house for $1,500,000. John’s separate property interest gets a “step up” in basis to it’s current fair market value of $750,000 (one half the current fair market value). Jane’s basis remains at $250,000. Therefore, the total basis in the property is $1,000,000 (John’s $750,000 basis + Jane’s $250,000 basis). When Jane sells the house for $1,500,000, there will be $500,000 of capital gains ($1,500,000 – $1,000,000 = $500,000).
Example of Taxes with Community Property: Same fact pattern as above, except John and Jane own their home as husband and wife, as community property. Upon John’s death in 2016, both John’s and Jane’s interest get a step up in basis, so that the new basis is $1,500,000 ($750,000 + $750,000 = $1,500,000). If Jane sells the home for $1,500,000, there will be no capital gains tax.
These examples are not intended to illustrate that title should be held as community property or separate property, but to explain the tax consequences of each. There may be other reasons, such as asset protection, to hold assets in a different manner that are beyond the scope of this article.
Estate Planning for California Community Property and Separate Property
Many estate plans do not adequately address the distinction between separate property and community property. An experienced Orange County Estate Planning Attorney at Modern Wealth Law can advise you on these complicated issues and discuss each asset on a case-by-case basis. Whether your concerns are divorce, death, taxes, asset protection or distribution, we can guide you on the proper way to take title to minimize risk and taxes, but maximize flexibility. You may call us at (949) 371-5003 or contact Modern Wealth Law by email, and John L. Wong or Anh P. Tran will be happy to discuss your options with you.
John Wong advises on all aspects of estate planning, probate, asset protection and trust administration. He believes that estate planning is about planning for life; while having protections in place should the unexpected occur.
