Gifts to Married Beneficiaries Living in Community Property States
“Gifts to Married Beneficiaries Living in Community Property States,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Constance Tromble Eyster, ACTEC Fellow from Boulder, Colorado. Attorneys in common law states often review community property laws when the clients have migrated from community property states. But it’s also important to consider the impact of community property laws and gifts by clients if the beneficiary is married and living in a community property state. To learn more about this topic, you’ll be hearing today from ACTEC Fellows, Katherine Akinc of Austin, Texas and Randall Grove of Vancouver, Washington. Welcome.
Thank you. We’re going to talk a little today about making gifts to persons in community property states. When faced with this issue, there are really a few big questions that shape the conversation. First being, who is the client — the donor or the recipient of the gift? The second being the type of asset being gifted; and third, what is the amount and the purpose of the gift? So, this is not always the case. But for purposes of our discussion today, we’re going to assume that the person making the gift is a parent, and that the gift recipient is an adult child living in a community property state.
Beneficiaries and Clients Living in Community Property States
As to the first point, who is the client? We already know the importance of this question. However, it can sometimes get tricky if you’re working with both parents and child to facilitate the gift. Remember, we’re talking about specific issues relevant when a child lives in a community property state, which means we’re talking about a married child. So, questions about whether the parents want the gift to remain their child’s separate property, the level of protection desired for the gift, and from whom the parents want to protect their child can sometimes get complicated.
Assets Gifted to Beneficiaries in a Community Property State
The second point to focus on is the importance of knowing the type of asset being gifted, particularly when the gift recipient lives in a community property state. So, let’s start with cash and a pretty common fact pattern, where parents want to gift money for their child to put toward a down payment on a house. Even if the child is married when a gift is made, all community property states hold that property received as a gift is the separate property of the recipient. What all parties should know, though, is that if the gifted funds are used to make the 20 percent down payment for the house but child and spouse sign a mortgage loan for the remaining 80 percent balance, this means that the child will own 20 percent of the house as her separate property but the community will own the other 80 percent of the house. If child and spouse were to divorce in the future, child’s separate property ownership of that 20 percent does not by any means guarantee that she’ll get to keep the house.
Contrast that scenario with the situation where the child is single when parents make the gift, and the adult child signs the mortgage note herself. In this scenario, the down payment is made with separate property and the mortgage note is the child’s separate property obligation. If child marries a few years later and community funds are then used to make mortgage payments on the loan, then if child and spouse were to separate in the future, the community might have a right of reimbursement for any amounts used to pay down the separate property mortgage obligation. However, the house remains the child’s separate property. So, if you want the home to be the married child’s separate property, then the child should be the sole person on the mortgage loan and it should also include recitations to confirm that the lender is only looking to the child’s separate estate for repayment.
Gifts of Securities or Cash to Beneficiaries in a Community Property State
Well, what if parents gift securities or just cash to a child in a community property state? Well, in a majority of community property states, income earned on separate property remains separate property. However, in Texas, Idaho, and Louisiana, income earned on separate property is community property. So, even if the child takes the gifted securities and puts them in a separate investment account held solely in her name, if the securities then declare dividends or if the cash earns interest, these dividends and this interest–that’s community property. And if that’s then used to purchase more securities in the same account, well, you can see how separate property and community property in that account could quickly commingle.
There are certain assets, such as real property or interests in a family limited partnership that might be easier to keep separate if gifted. If the real property is not subject to a mortgage, or if the entity doesn’t require additional capital contributions, then there is less of an opportunity for commingling to occur.
Finally, in general, gifting assets subject to a trust, rather than outright, will often help maintain the character. But whether a trust is the right fit or not gets to the size and the purpose of the gift. And for that, I’m going to turn it over to Randy.
Impacts of Amount and Purpose of Gifts to Beneficiaries in Community Property States
Thanks, Kat. The amount and purpose of the gift will then implicate the level of protection that’s needed in the particular situation. To start with, if the client is simply wanting to make an annual exclusion gift to their married child on a one-time basis for a particular purpose and the money is going to be expended soon, well, that’s not something that we need to give a lot of intensity to, protection wise. But if it’s a situation where it’s ongoing gifts or if it is a major strategic gift utilizing the parents’ lifetime exclusion, gift tax exclusion, then that’s a whole other story. So, we get to the intent of the parents relating to the purpose of the gift.
And the question I like to ask is: what is the role that the parent intends that the gift plays in the life of the donee, of their adult child? Because it may be a situation where this is really intended to accumulate for the future and be flexible for various kinds of special distributions and best interests of the child or that child’s tax planning; or the particular level of benefit might be for ongoing lifestyle support. Now, if the level of access is simply for accumulation for the future and other special matters, then it might be sufficient to have a level of protection that just clarifies the situation. That is, as Kat was mentioning, going ahead and putting the asset, making the gift to a separate property account for the adult child. And also, parents can prepare a memorandum of gift that states the source of the gift, what their intent is, that is, that it’s to be used for the benefit of their adult child for special purposes, not for ongoing lifestyle, and is to be part of the legacy going down to the next generation.
If there’s a situation where the child is fully on board with parents, has a stable marriage, just having clarity may be sufficient. I’d call that water repellent protection, certainly not waterproof.
Then, the next level of protection is establishing an irrevocable trust by parents. Certainly, having an independent trustee is going to be increasing the level of protection as well, and then there can be greater discretion and certainly for tax purposes. The maximum protection that is demonstrated through distributions would be where the trust gives the trustee discretion to provide distributions for best interests of the beneficiary rather than any mandated distribution, such as for health, education, support, and maintenance or ongoing support.
If it is satisfactory to just have the best interest distribution, then the level of protection that the trust is going to give is going to be quite high. One of the other considerations is whether the state law of the community property state is what I’ll call an equitable allocation state, such as the state of Washington; I believe the state of Texas is as well, where the judge upon divorce can take into account both community property and separate property in making an equitable allocation between the divorcing parties, or whether it is a state that provides for equal division of community property, and separate property goes to the owner of the separate property. I believe that California would be that kind of state.
If the state law provides for the equitable allocation and if the trust provides for ongoing support, then just the trust alone that characterizes the assets as separate property is not going to be sufficient protection, possibly upon divorce, because the judge will take into account the ongoing lifestyle support that the trust provided. In that type of situation, then another level of protection is needed as well. That would be a post nuptial agreement, sometimes called a property status agreement. However, if the state is the equal division of community property and allocation of separate property solely to the owner of that separate property type of state, then the trust will be adequate protection, if the usual types of approaches are built in as well. And I would certainly recommend having an independent trustee. So, that is a summary of the amount and purpose and level of protection considerations. Thank you so much.
Thank you both for educating us on the myriad of issues arising when clients make gifts to married children living in community property states.
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