Community Property Trumps Separate Property
Over the last month I have given several all-day seminars on farm taxes and we usually have a discussion on community property versus separate property. There are only 9 states in the US that are community property states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. All others are separate property states.
The reason that community property trumps separate property is via the step-up in basis for property owned one or both spouses. In a separate property state, only the spouse who legally owns the property will create a step-up upon their death. Whereas in a community property state, it does not matter who owns the property, there is a 100% step-up (in some cases, property created jointly before 1977 will create community property for step-up purposes even in a separate property state).
Let’s look at an example:
John and Mary own farmland in Iowa. John owns 99% of the farmland and Mary owns the other 1%. The land cost $1 million and is now worth $10 million. Mary passes away in 2019 and John inherits the land. He can step-up 1% of the land ($100,000) from Mary’s cost of $10,000. Now, let’s assume that John and Mary live in Washington state. In this case, John can step-up the value of the land to $10 million and sell it for $10 million tax-free.
This is the power of community property. Now many of you will say “I don’t want to move to any of those states”. You can still create community property via using a trust. There are currently three states that allow community property trusts (Alaska, South Dakota and Tennessee). A couple in a separate property state could transfer assets into a community property trust in one of these states and create “community property” for those assets.
This could be very beneficial for any couple where one spouse is in ill health and there is a strong chance that the asset would be sold after the death of the first spouse.
This is a very complex issue (and the IRS has never ruled on these trusts) and should be discussed with your tax professional, but in many situations the community will trump the separate.
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
I am not in a community property state, so I am sure you in community property states already know the answer to this. If you are in a community property state or setup a trust in a community property states as discussed above, does that mean that when you file the Form 706, you have to include the value of the surviving spouse property in the decedents estate? Therefore, using the example above, Mary’s estate would now include $10,000,000 in a community property state instead of $5,000,000?