The Community Property Step-up - Zehner Davenport Group

For the past eight weeks we have been featuring an update of our popular series, The Wealth Cycle, which we first brought to you back in 2016. The Wealth Cycle concept is our way of looking at the shifting goals of investors over time. We break it down into three main phases that you can review with the links below.

Read the Previous Posts in This Series:

In our most recent post, we looked at the step-up rule as a viable estate planning strategy when investors reach the wealth distribution phase, the time in life when we make plans to pass on the remainder of our wealth when we are gone.

The step-up rule gives us the opportunity to bequeath our assets to heirs at a cost basis equal to current asset value when we pass away. It is perhaps the best tax planning tool of all time, as our highly appreciated assets can be sold immediately without any of the taxes we would pay if those same assets were sold while we are alive. So, a property you bought for $400,000 that is worth $4,000,000 when you die, can be sold by your heirs for $4,000,000 without paying a nickel in taxes. Anybody who doesn’t think that’s a pretty good deal is impossible to please.

We also made note in our last post of partial steps up in basis that occur inside families over time that reduce rather than eliminate tax liability. Today, we cover a lesser known, but highly impactful aspect of the step up rule: the community property step up. We are guessing that most of you reading this post will be surprised, maybe even shocked, to hear how it works. We say that because probably four in five of those we discuss it with had never heard of it, yet the benefits can be profound.

Before we get into the details, let us say that the topic is somewhat uncomfortable to discuss because it involves the death of a spouse, something none of us wants to contemplate. That said, we bring it up to get that out on the table and look at it as an effective estate planning tool.

So, how does it work? A little background first. There are 9 states in the US that are designated as community property states. They are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Generally speaking, this means that all assets that are acquired, and/or maintained with money earned by either spouse during the marriage can be designated as community property and are co-owned by both spouses equally. There are exceptions, of course. Either spouse can own separate assets, but those assets must be identified and separately serviced to keep them out of the community. Thus, Mrs. Jones, who owned a commercial property before marrying Mr. Jones can designate that asset as separate property, but she must be careful to maintain that asset with funds also designated as separate. We won’t focus on that here, but suffice to say that care should be given to the issue of separate vs. community ownership going into a marriage.

Since the right of survivorship goes with their community assets, those assets are automatically passed on to Mr. or Mrs. Jones when one of them dies. When that time comes, the surviving spouse gets a 100% step up in basis to the value of assets as of the date of the deceased spouse’s death. Most clients we speak with assume that they would receive only a 50% step up upon the death of a spouse. That’s where the advantage of living in a community property state comes in. Important note: it is advisable to clearly designate ownership of assets as “community” assets and not just as “joint tenants”(as is often the case with real estate vestings) to make assure that a full asset step up occurs when one spouse passes.

Let’s look at a simple example: say Mr. and Mrs, Jones bought a 15,000-square-foot building in 1993 for $55 per square foot or $825,000. The property is now worth $380 per square foot or $5,700,000. That’s a huge gain if they sold the building today at that price. After all the calculations are done, that probably means state and federal taxes due on the sale of almost $2,000,000 assuming they are both still alive.

However, because California is a community property state, if one of the Jones passes away while they still owned the building, it could be sold for what is was worth on the date the one spouse passed (via the community property step up) and the surviving spouse would pay $0 in federal or state taxes. Most investors we speak with don’t even believe us when we explain this because it sounds too good to be true. Then they confirm it with their tax accountant, but still find it hard to believe that the taxing authorities would allow such a huge gain to go completely untaxed.

The community property step up applies to other asset classes, not just real estate. This gives a surviving spouse tremendous power to distribute assets to heirs while they are alive with minimal tax implications to themselves or their heirs. This is especially important when the value of the estate exceeds the threshold for protection from estate taxes. More on the community step up and estate taxes in our next post. Stay tuned.

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