The Internal Revenue Code (Code) provides substantial income and estate tax benefits to the married residents of the nine “community property” states. Two other states – Alaska and Tennessee – allow married couples to opt in to their community property regimes and reap these benefits.
In addition, Alaska and Tennessee offer married residents of the other 39 “common law” states (including Virginia) a way to reap these benefits by using Alaska’s or Tennessee’s community property laws. This technique has been used widely since 1998, when the Alaska Community Property Act was passed. And the increases in federal income and capital gains tax rates and surcharges first initiated in the Patient Protection and Affordable Care Act (“Obamacare”) and the 2010 and 2012 Tax Acts are still in effect. They have made Community Property Trusts much more attractive to Virginia couples facing potentially high capital gains taxes.
The Capital Gains Tax Problem
Americans hate to pay capital gains taxes. They hate them to the point that they sometimes disadvantage themselves in other ways to avoid having to pay them. For example, stock and bond portfolios can become unbalanced, or overweighted in a few low-basis stocks, because their owners refuse to sell. A no-longer-youthful real estate investor might tire of managing rental real estate, yet delay sales of his or her properties because of federal and state capital gains taxes and surcharges.
Current Federal Capital Gains Tax Rates
Under the Patient Protection and Affordable Care Act of 2010 (“Obamacare”) and the American Taxpayer Relief Act of 2012, Congress substantially hiked capital gains taxes for high-income taxpayers. Here’s how federal long-term capital gains tax and surtax rates have jumped in the last decade for married couples filing jointly:
Adjusted Gross Income Old Rate Current (2022) Rate (including NIIT)
$83,350 to $517,200 15% 18.8%
Over $517,200 15% 23.8%
Add State Capital Gains Taxes
Many states have their own capital gains taxes. For example, California’s top marginal rate is 13.3%; New York’s is 8.8%, and New Jersey’s is 10.75%. Virginia’s top marginal rate is a relatively modest 5.75%, but when added to the federal capital gains tax, that still equals almost a 30% hit when highly appreciated securities or real estate are sold.
Add Recapture of Depreciation
For depreciated property (such as rental real estate), a 25% tax rate applies to recaptured depreciation. The 3.8% Obamacare net investment income surtax also applies to recaptured depreciation if you have joint adjusted gross income of more than $250,000.
Example: Bob and his wife Jane own an apartment building in Richmond that they purchased for $1 million in 1978. It is now worth $10 million. If they sell it, they will have a gain of $9 million. The property has a depreciated basis of zero, so they will also have $1 million of depreciation recapture. They have more than $517,200 in other income. Here’s what will happen, approximately, if they sell their apartment building (and why they may feel like putting off such a sale):
20% Federal capital gains tax (on $9 million) $1,800,000
25% depreciation recapture tax (on $1 million) 250,000
3.8% Obamacare NII surtax (on $10 million) 380,000
5.8% Virginia capital gains tax (on $10 million) 580,000
Total Taxes on the sale $3,010,000
The “Hold Until Death” Capital-Gains Strategy
Code Section 1014 provides that the basis of property acquired from a person who dies that is included in his or her estate for estate tax purposes is its fair market value at 1) the date of his or her death or 2) optionally in a few cases, six months after the date of his or her death. Generally, this results in a “step-up” in basis as most property appreciates in value over time due to the effect of inflation. (A “step-down” in basis occurs if the market value goes down instead of up between acquisition and death.)
As a result, many Virginians are tempted to hold onto appreciated property until they both die so that their children will get a step-up in basis.
Common-Law State Example #1: Assume that Bob is the sole owner of the apartment building and left it to Jane upon his death in 2021. Under Code Section 1014, Jane receives a step-up in basis to $10 million, the fair market value of the property. If Jane had sold immediately, there would be no tax on the gain or depreciation recapture – a tax savings of more than $2.9 million.
Common-Law State Example #2: Assume Bob and Jane own the building jointly (most likely as tenants by the entireties), and Bob died in 2021. Code Section 1014 provides Jane a step-up in basis on Bob’s half of the property, to $5 million. Added to Jane’s zero basis on the other half, that results in a new basis for Jane of $5 million. Upon sale by Jane at $10 million, capital gains tax and recapture would still be just over $1.5 million.
The Community Property Difference
Community property states have marital property laws that were derived (or imported) from Spanish or French civil law, distinguishing them from Virginia and the other common-law states, whose marital property laws were derived from English law.
Each state’s community property law is slightly different but, in general, the community property form of ownership is analogous to a business partnership. Each spouse has a one-half “undivided interest” in the community property, meaning that the property is held as a whole and cannot (barring divorce) be divided into “His & Hers” shares.
Community Property Basis is Adjusted More Favorably
Code Section 1014 provides a special basis rule for any community property owned by a person who dies and his or her spouse. For community property, the Code Section 1014 basis adjustment applies to both the decedent’s interest in the property and the “property that represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any state.”
That’s worth reading again. Here’s an example of how it works:
Community Property State Example: Assume Bob and Jane own the apartment building as community property. When Bob dies, the property, now owned solely by Jane, will receive a full step-up in basis to its fair market value of $10 million. If Jane sells it for $10 million, there will be no capital gains tax. Community property treatment thus saves Jane, the surviving spouse, about $1.4 million in capital gains taxes right then, during her lifetime. If Jane doesn’t sell immediately, and continues to operate the rental building, she can depreciate the property’s improvements starting at its new basis of $10 million minus the value of the land.
The result is that under a community property regime, owners of appreciated real estate (or marketable stocks or family businesses) may avoid all capital gains taxes upon sale after the death of the first spouse.
The Community Property Trust
Good news! Bob and Jane do not have to move from Virginia to a community property state (and then enter into an agreement converting their marital property into community property) to achieve the result in the community-property state example above. Instead, they can, while remaining Virginia residents, establish an Alaska Community Property Trust or a Tennessee Community Property Trust, and simultaneously transfer the appreciated property to it and convert it to community property.
A Community Property Trust allows Bob and Jane to “borrow” one of those states’ opt-in community property laws and have their low-basis property characterized as community property.
How a Community Property Trust Works for Virginians
Married couples who are not Alaska or Tennessee residents (such as Virginia residents) who wish to opt in to one of those community property regimes will begin by creating an Community Property Trust. Under the applicable laws of Alaska and Tennessee, nonresident couples should specify, in a written Community Property Trust agreement, which trust assets they want to convert to community property.
A Community Property Trust is a joint revocable living trust. Under the Community Property Acts of those opt-in states, it must have an in-state trustee, which can be an Alaska or Tennessee bank or trust company that exercises trust powers in the relevant state, or an individual whose domicile is in the chosen state. Also, the in-state trustee must have certain specified powers and responsibilities regarding the trust. These do not have to be exclusive powers of the in-state trustee. Thus, Virginia grantors may (and usually will) serve as co-trustees to manage the property and assets held in the trust. Generally, they will choose to receive the trust income and, upon the death of the first spouse, have the trust assets “pour over” into each of their Virginia revocable living trusts.
Virginia resident grantors may, of course, continue to have their Community Property Trust assets managed by their current advisors (or continue manage them themselves, if that is their style).
How much does it cost to maintain your Community Property Trust? In 2022, An Alaska or Tennessee bank or trust company’s annual trustee fee for the minimum services and responsibilities required by the Community Property Act is likely to be around $2,500 to $3,000 per year. Fees are not fixed by law, so a trustee might sometimes charge less, especially if the grantors have another relationship with the bank or trust company.
Who are good candidates for Community Property Trusts?
Virginia couples who may wish to consider establishing an Community Property Trust are those who:
- Are in a long-term, stable marriage;
- Own (either jointly or individually) highly appreciated real estate, stocks, family business interests, or low-basis personal effects or collections (such as art, fine jewelry, or precious metals that have appreciated in value); and
- Contemplate that a surviving spouse would likely (or at least possibly) want or need to sell the appreciated property. This might happen because the survivor decided to move out of a low-basis home, or wanted to reduce her portfolio concentration of a particular financial or real estate asset, or just wanted to turn a particular asset into cash or more-liquid securities for peace of mind; or
- Contemplate that a surviving spouse would likely (or at least possibly) gift the appreciated property to children or grandchildren in trust – but with the stepped-up basis that resulted from the death of the deceased spouse.
If one spouse is in poor health, or substantially older than the other, or engages in risky activities, then those factors should be taken into account as well. However, accidental death or unexpected illness can occur at any age to otherwise hale and hearty people. The absence of any current health problems doesn’t mean you should rule out a Community Property Trust.
Who are poor candidates?
Community Property Trusts aren’t for everybody: For example, they probably aren’t suitable for couples who:
- Are recently-married and aren’t fully confident that they know each other yet, especially if they are still keeping their property separate; or
- Have an unstable marriage; or
- Have little or no appreciated, low-basis property; or
- Are in a second (or subsequent) marriage with prior-marriage children, where property is kept separate and one spouse is substantially “richer” than the other.
If you believe a Community Property Trust might be right for you, or you’d just like more information, I invite you to contact me so that we can set up a meeting to discuss your situation in depth. I’d be pleased to help you set one up.