What is Community Property?
by ACTEC Fellows Michelle B. Graham and Todd J. Schneider
Nine states in the United States are community property states. Understand what community property is, how that affects assets such as a home or a business, what is quasi-community property, and what happens if you buy a vacation house in a community property state. ACTEC Fellows Michelle B. Graham and Todd J. Schneider also discuss the impact of death or a divorce, and what might happen if you own a business in a community property state.
Hi, I’m Todd Schneider and I’m an ACTEC Fellow from San Diego. With me today is Michelle Graham.
Hi. I’m Michelle Graham, also an ACTEC Fellow from San Diego, California.
And we’re going to be talking to you today about community property in estate planning. So, Michelle, what is community property?
So, community property comes into play — and we’ve got nine states in the United States that are community property states. Community property means that spouses who acquire property during marriage own property equally, 50/50. That means that one spouse on death can leave his or her share as he or she wants and on divorce, it typically is divided 50/50 as well. Separate property, on the other hand, is property that’s acquired during marriage by gift or bequest and also property that’s brought into the marriage. And then we have something called quasi-community property, that not everybody’s heard of. Quasi-community property is property that a couple who is domiciled in California acquires while in California, and that’s located in a common-law state. So, a state other than a community property state.
And so, Michelle, what are some of the common misconceptions about community property?
So, one of the main misconceptions that I see is that a couple, for example, from a common-law state who buys property in California — that property will automatically be community property. That’s not the case. If they’re not domiciled in California, they’re not going to be subject to our community property rules.
And so, what happens if a couple who is domiciled outside of the state of California, or any other community property state, moves into a community property state such as California and they’ve acquired property in, let’s say, a state such as Florida? That’s a common law state.
Right. So if they come to California and they have been married and are bringing their assets into California, that will be considered quasi-community property. And it will most likely then be considered community property in California. Also, if they have separate property — just because they’re moving into California doesn’t automatically make it community property. Something needs to be done in order to, what we call, “change the characterization or transmute the property” from separate property to community property.
So, what happens if you have a couple that lives in a non-community property state, but they acquire property in California or another state such as California that’s community property? Does that property automatically become community property in that other common law state?
No. It doesn’t. In order for that property to be considered community property, the individuals would need to be “domiciled.” And that’s a term of art in California. It’s defined under our probate code. But they need to have California be their permanent place where they intend to remain. So, if they’re simply purchasing a vacation home in California — we see that quite a bit — just because they buy property in California doesn’t automatically subject them to our community property rules, which of course then come into play on death or divorce.
What happens in the event that a couple decides to change the character of their property? Is that something that they can do by simply signing a piece of paper or recording a deed or is there some other type of document that needs to be recorded?
It is certainly something that couples can choose to do. So, if they come into California and they have separate property, for example, and they want to change that to community property, they can enter into an agreement to change that characterization. And you mentioned a deed. So, most often with real estate, you would have a deed that would be recorded that changes the property and clearly states on the face of it that the properties are now changing it from an individual separate property into the couple’s community property. When it comes to the other property that the couple owns, we would typically recommend that they enter into a marital property agreement and that both spouses be represented so they can have fair representation and explain what the rules are; and that’s drafted in accordance with the family code in writing and fully explained what they are changing the characterization of their property to.
Michelle, are there any specifics tax benefits to having community property other than the – you mentioned the probate situation and you mentioned death and divorce – are there any other benefits as well?
There are. One of the benefits with community property is that the property receives a full step-up in basis. So what that means is if the couple purchased shares, for example, that were worth $100 and on the death of the first spouse, they’re worth $1,000, the new basis in the property will be $1,000. Thereby, the $900 appreciation goes away completely and will not be taxed. So that’s a big benefit. And then when the second spouse dies, it’ll get another step-up in basis if the property has appreciated again.
Are there specific rules with respect to income that’s earned during the marriage of community property or separate property? For example, if I were to bring in a business into the marriage and I’m working at that business, do I have community property or do I have separate property with respect to the income that I’m earning?
You’ve probably named one of the harder assets really to deal with. The easier assets — if you have income from separate property from like dividends or interest, that will track the asset. So, if the asset is considered separate property, the income from the asset will be considered separate property. Unless, of course, the couple agrees otherwise. The same thing with community property. The income will be community from a community property asset. The tricky asset is the business because what happens is you’re putting time and effort into that business and the question will be whether you were adequately compensated. And so, even though you thought “Hey, I brought this business into the marriage, this is my separate property, that’s the way the laws work,” there could be an argument. Most often we see it on divorce that the other spouse, the nonworking spouse, has somehow acquired a community property interest in that because the income and the work and the personal services that you put into that business were community property. But, good question. Tough to answer, though.
And with respect to separate property, is that something that I can do whatever I want with it or are there any restrictions when I pass away or in the event of divorce? Does that become my property automatically?
Separate property is your property; and you can certainly bequeath that to whomever you’d like to. Yes.
Very good. I think on that note, thank you very much, Michelle for those wonderful answers on community property.
My pleasure. Thanks.