Understanding Community Property: Essential Considerations for Estate Planning

When it comes to estate planning, the state where you live — or have lived — can significantly impact your wealth transfer strategies. One of the most important factors to consider is whether the state follows community property laws. These laws, which apply in nine states, can affect everything from tax planning to how trusts are structured. Understanding these rules is crucial for effective estate planning, whether you currently live in a community property state, used to live in one, or are considering a move to one.

What Is Community Property?

Community property is a legal framework that governs how married couples own assets. Nine states follow community property laws: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In these states, most property acquired during marriage is considered jointly owned by both spouses, regardless of whose name appears on the title or who earned the income to purchase it.

The specifics vary by state, creating important nuances for planning purposes. For instance, while some community property states treat income generated from separate property (property owned before marriage or received as a gift or inheritance) as community property, others do not. These variations can affect creditor exposure and management rights, making it essential to understand the specific rules in your state.

Additionally, some states recognize “quasi community property” — property that was separate when acquired but is treated as community property in the event of divorce or upon the death of a spouse.

How Can Community Property Laws Impact Your Assets?

Community property laws matter for several critical reasons that can directly impact your estate and financial planning.

First, mobility is increasingly common in our society. Many clients move between states during their lifetimes, potentially shifting from separate property states (like Illinois) to community property states, or vice versa. These moves can alter the legal characterization of your assets and may require adjustments to your estate planning documents.

Second, divorce implications can be substantial. Community property laws determine how assets are divided in divorce proceedings, which can differ significantly from the equitable distribution approach used in separate property states. Understanding these differences helps inform both estate planning and prenuptial planning.

Third, basis planning opportunities arise from community property’s unique tax treatment. Under federal tax law, community property receives a full step-up in cost basis at the first spouse’s death, meaning both halves of community property assets receive a stepped-up basis to fair market value as of date of death of the first spouse to die (and then again on the second spouse’s death). This can result in significant capital gains tax savings compared to separate property, which only receives a stepped-up basis on a deceased spouse’s share of joint property.

Joint Trusts and Community Property

The relationship between joint trusts and community property creates both opportunities and considerations for estate planning. Joint trusts — where both spouses are grantors of a single trust — are particularly well suited for holding community property assets because they mirror the joint ownership nature of community property itself.

When community property is held in joint trusts, it maintains its character while providing the management and distribution flexibility that trusts offer. This structure can be especially beneficial for tax planning purposes, as it clearly delineates community property to ensure that basis adjustment rules would apply upon the death of a spouse.

However, separate trusts may still play important roles in comprehensive estate planning, particularly for holding separate property assets or achieving specific tax or asset protection objectives. The key is understanding when each structure serves your goals most effectively.

Strategic Planning Considerations

Effective community property planning requires different approaches depending on your circumstances and objectives.

For clients moving from community property states to separate property states like Illinois, the general rule is that community property retains its character after the move. This preservation can be advantageous for basis planning purposes, often making it worthwhile to maintain existing joint trust structures that hold community property assets.

Conversely, clients moving from separate property states to community property states should consider whether adding joint trusts to their planning makes sense. They might also explore converting separate property to community property through a property agreement, which can allow access to the favorable tax basis rules that apply to community property.

Gift planning presents additional opportunities and complexities. The characterization of property as community or separate affects gifting strategies, particularly when funding gift trusts for a spouse. Property agreements can help clarify and potentially modify property characterization, but timing and proper legal representation are crucial.

For clients in separate property states who want to access community property benefits, several states offer community property trusts. Florida, Kentucky, Alaska, South Dakota, and Tennessee allow non-residents to create trusts that hold assets as community property, potentially providing a double step-up in cost basis without requiring a move.

Moving Forward With Confidence

Community property laws create both opportunities and complexities in estate planning. Whether you’re dealing with existing community property, considering a move between states, or exploring community property trusts, understanding these rules is essential for maximizing your planning and avoiding pitfalls. Working with experienced estate planning counsel can help you navigate these considerations and develop strategies that align with your family’s unique circumstances and objectives.

Facing questions about community property laws? Reach out to Mari Berlin (Mari is licensed in Illinois and California), Stuart Kohn (Stuart is licensed in Illinois and Arizona), or another member of LP’s Trusts & Estates group.