Common Law Property vs Community Property: Who Cares? The Impact on Basis of Property
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What is the Distinction between These Two Treatments: Common Law and Community Law?
Most taxpayers with reasonable training in personal, financial issues and business issues know the difference between Common Law Property (CLP) ownership versus that of Community Property (CP) ownership.
When considering this property issue as, what happens to the basis of property on the death of a property owner, as opposed to a discussion on marital property in a divorce or dissolution of the marriage, there may be a less clear understanding of the import of this Common Law vs Community Law distinction.
What is the Impact of Death on the Basis of Property?
The purpose of this Tip is to focus on a specific area of importance when applying this distinction of how the basis of property is impacted, for Federal Income Tax purposes when property, held by the decedent, was held as Common Law Property or Community Property.
This distinction is very, very important in many instances. A simple example illustrates this distinction:
If X owned X-1 property and X died, what is the basis of the property to a beneficiary of X-1, that is his spouse, Y?
Thus, if the X-1 property was worth 1 million dollars on the death of X, but the federal income tax basis of the property to X was only $200,000, there is appreciation associated with this asset of $800,000. (See Internal Revenue Code 1014.)
If Y, the beneficiary from X, takes the X-1 property, the basis, because of the Code Section cited, viz., Section 1014, “steps up” the basis to Y. It is stepped up or moved up to the fair market value, in most cases, as of the date of death of X. This means that if Y sells X-1 for the 1 million value, there will be no taxable gain to Y. This is good news for Y. However, what if the property held by X was also held by X with his wife, Y? That is, what if the property was owned as tenancy in common between X and Y? Take the same example: X, dies and Y takes the X-1 property. What is the basis to Y? The answer to this question, in most cases, is:
1. If the property was owned by X in a Common Law state, the basis to Y is increased to the fair market value, but only on the part X owned. That is, the step up means the basis from X is $500,000 in this example. Thus, Y has a basis of ½ of the property’s basis before death and then Y has a basis of $500,000 on the part the spouse takes from X. Thus, the total is $600,000 for the basis.
2. If the property was owned by X in a Community Property Law state, the basis to Y in the above example, when taking property from X, is the full $1 million value.
This example shows an apparent advantage to beneficiaries in the Community Property Law state. Because of this position, some states that are normally Common Law states have provided an option to allow their citizens to designate property—in whole or in part in these states—as Community Property. That is, even if you are in a Common Law state, you can, through proper procedures (often requiring to set up a Community Property Trust), create a Community Property setting in what is normally a Common Law position. Several states now allow this treatment, such as Alaska, Tennessee, etc. and Florida recently passed legislation to allow this Community Property Law position.
This treatment of some property as Community Property is a huge advantage as to the step up in basis position! See the example, above, and note how in a Common Law position the basis is hugely impacted by this difference.
Of course, there are negative issues to consider as to this treatment; such concerns could arise if the property is deemed Community Property and there is a divorce or dissolution. However, when looking at the income tax issue, the step up in basis is a very valuable benefit.
For more on this and related issues, see Levine, Mark Lee and Segev, Libbi Levine,
Real Estate Transactions, Tax Planning, (Thomson Reuters West 2022).