Community property agreements (“CPA”) may provide estate planning benefits if designed for the married couple involved.
1. All Property Not Converted to Community Property Upon Marriage.
Many people mistakenly believe that once they marry all of their property magically becomes community property, and upon the death of one spouse it automatically transfers to the surviving spouse. This is not true. Unless a married couple signs an agreement or commingles their separate and community property, gifts, inheritances and property that a spouse owned before marriage remain separate property. Property acquired during a marriage with separate property remains the separate property of the spouse who owned the separate property. Community property consists of wages earned during the marriage, property purchased with the wages earned during the marriage, and property converted to community property.
For example, before David and Martha marry, Martha owns a brokerage account worth $200,000, and David owns a brokerage account worth $150,000. David and Martha marry. Martha does not add any money to her brokerage account after the marriage. Martha’s brokerage account remains Martha’s separate property. Martha and David make monthly contributions to David’s brokerage account. David and Martha commingle the funds in David’s brokerage account, thus creating the presumption that it is community property.
2. Power to Distribute Community Property at Death.
Each spouse can leave his or her half of the community property and all of his or her separate property to whomever he or she desires.
For example, David and Martha each have children from a prior marriage. David and Martha married in 1985. David and Martha both work outside of the home and have built up community property assets of $800,000. Martha also owns a brokerage account of $200,000 from her first marriage which she kept as her separate property. Martha signs a will leaving all of her separate property and community property to her children from her first marriage. Martha’s children will inherit one-half of the community property ($400,000) and her separate property ($200,000). Martha’s children from her first marriage will inherit a total of $600,000. David will retain his half of the community property ($400,000).
3. Benefit of Community Property.
The benefit of community property is that the tax basis of a deceased spouse’s community property changes to the fair market value of the asset at the time of the spouse’s death.
For example, David and Martha purchase stock at $85 per share. David dies. On the date of David’s death, the stock sells at $150 per share. All of the stock changes its tax basis to $150 per share. This means that if Martha sells the stock for $150 per share, she reports no capital gains.
In comparison, Martha acquires the stock with her separate property at $85 per share. David dies. On the date of David’s death, the stock sells for $150 per share. None of the stock changes tax basis for capital gains. If Martha sells the stock for $150 per share, she would report a gain of $65 per share.
4. Changing All Property to Community Property.
A couple can change all of their property to community property by signing a CPA in the presence of a notary public. Community property agreements come in two basic varieties: a vesting CPA and a nonvesting CPA.
5. Vesting Community Property Agreement.
The vesting CPA states that all of the property owned by the husband and the wife is community property, all property that they acquire in the future is community property, and when one of them dies all of the community property automatically passes to the surviving spouse. Married couples with assets less than the amount exempt from both the federal estate taxes ($11,580,000 in 2020 adjusted for inflation) and Washington state estate taxes ($2,193,000 in 2020) use a vesting CPA. A surviving spouse may file a vesting CPA and a certified death certificate with the county auditor on the first spouse’s death and avoid probating the spouse’s estate in Washington state. The surviving spouse would also need to file an excise tax affidavit listing all of the real property being transferred using the community property agreement.
6. Nonvesting Community Property Agreement.
The nonvesting CPA states that all property owned by the husband and the wife is community property and all property that they acquire in the future is community property, but it does not distribute all of the community property to the surviving spouse. Married couples with assets in excess of the amount exempt from estate taxes use a nonvesting CPA so that all of the assets owned by the husband and wife achieve a tax-basis change at the time of the first death. However, it does not pass the assets directly to the surviving spouse. Instead, the deceased spouse’s share of community property passes under the deceased spouse’s will as the deceased spouse directs.
For example, David and Martha own assets worth $4,000,000. They sign a nonvesting CPA. Martha dies in 2020. All of David and Martha’s property changes its tax basis to the fair market value on the date of Martha’s death. David owns assets worth $2,000,000 and Martha’s estate owns assets worth $2,000,000. The $2,000,000 owned by Martha’s estate can fund a bypass trust under Martha’s will and avoid estate taxes.
In comparison, David and Martha own assets worth $4,000,000. They sign a vesting CPA. Martha dies in 2020. All of David and Martha’s property changes its tax basis to the fair market value on the date of Martha’s death. David owns the entire $4,000,000 on Martha’s death. If David dies in 2020, then David’s estate will owe approximately $212,980 in estate tax.
A CPA can terminate upon a specified event such as changing domicile from Washington State to another state, or by the parties signing another agreement revoking the CPA in the presence of a notary public. If the CPA terminates upon filing for divorce, it can make property acquired after the filing the person’s separate property and prevent the property from automatically transferring to a spouse if a person dies during the divorce proceeding.
A CPA must be recorded if it is used to transfer real property. Another benefit of recording is that a certified copy of the CPA can be obtained from the county auditor’s office if the original is lost. If a couple revokes a CPA, that revocation should also be recorded with the county auditor.
9. The Problem With Community Property Agreements.
A CPA may affect a married couple’s property rights if they divorce, since property ownership changes not only for tax purposes, but also for ownership and divorce purposes. If a person is considering leaving a marriage, he or she should not sign a CPA.
For example, before David and Martha married, David owned $200,000 in assets and Martha owned $400,000 in assets. David and Martha sign a CPA making all of their property community property. A year later, David files for a divorce. Now David can argue that he owns one-half of $600,000 ($300,000) instead of only $200,000 in separate property that he brought to the marriage.
The benefits of a CPA for estate planning purposes include a change of tax basis on the death of the first spouse, and the ability to avoid probate on the first spouse’s death if a married couple signs a vesting CPA. Of course, a couple must consider the potential problems that may arise if they divorce. In addition, people who do not want their assets to automatically pass to their surviving spouse, including for tax reasons, should not sign a vesting CPA.