Most married couples are comfortable with the idea that what belongs to one spouse belongs to the other. It's fairly common for spouses to commingle their assets into a single pool, often in joint accounts in which it would be difficult to trace who was responsible for contributing certain amounts. Even when it comes to income, many couples don't pay much attention to which spouse earns more or less money; it all goes into the joint checking account and pays the whole family's bills.
A few states, including Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington, incorporate this idea of joint family property management into their laws. In these states, community-property laws govern the property rights of married couples. The existence of community property gives married couples some opportunities not available to couples in other states. However, it also presents some additional challenges for couples to overcome.
What community property is
The idea behind community-property laws is that during the period when two people are married, they are both contributing to a family unit. Therefore, any assets that come from the efforts of the family unit belong to both spouses rather than just the one whose name happens to be on the paycheck.
Community-property laws divide property into two categories: separate property and community property. Separate property is treated in the same way as the property that unmarried people own. Only married people, on the other hand, can own community property. For the most part, any property that either spouse receives during marriage is considered to be community property. If a spouse owned assets before getting married, then those assets are treated as separate property. In addition, if a spouse receives a gift or inheritance during marriage, any assets the spouse receives in this way also represent separate property.
In general, states with community-property laws carry a strong presumption that all of the property a married person owns is indeed community property unless that person can show that it's actually his or her own, separately. This holds true regardless of whether a certain account has the names of both spouses or is registered in only one spouse's name.
Division of community property
When a marriage ends, either by divorce or death, community property is generally treated as being owned 50% by each spouse for purposes of applying laws governing division of property. In divorce, this doesn't necessarily mean that each spouse will get exactly 50% of the community property; states that have laws governing equitable distributions often allow unequal division of property to reflect different levels of financial resources and abilities to earn a living. However, it does provide a starting point for a court to consider how assets should be divided.
One consequence of the 50% rule is that, at death, the surviving spouse is generally entitled to 50% of the community property, regardless of the provisions of the deceased spouse's will. Because community property belongs to the family unit, neither spouse is able to disinherit the other. This stands in contrast to states that don't have community property laws, many of which have far less generous provisions for disinherited spouses.
Tax benefits of community property
A strange quirk in the tax code gives married couples in community-property states a definite advantage over couples in other states. In general, when a person dies, the tax basis of the property that person owned changes to the value of the property on the date of death. This is usually referred to as a basis step-up, because the provision most often causes an increase in basis. The net result is that heirs can sell property without incurring capital gains tax liability.
In most states, when a spouse dies owning joint property, that spouse's half of the joint property gets a basis step-up. So, for instance, if you own a stock jointly with your spouse that is worth $100 at your death and you paid $10 for it, then the basis of your half of the property will rise from $5 to $50. Your spouse would therefore have a total basis of $55: your basis of $50 plus your spouse's basis of $5. If your spouse sells the property, therefore, the capital gains from your half of the property effectively disappear, leaving only the gains on your spouse's half.
In community-property states, however, the IRS gives a basis step-up to the entire community-property interest. In the above example, this means that the basis of all of the stock rises from $10 to $100. This eliminates all capital gains if your spouse subsequently sells the stock. You can take advantage of this provision by making sure that if you've invested in stocks that have appreciated substantially, such as Yahoo!
As you can already see, community property has some interesting characteristics. In addition to saving capital-gains taxes, there are some other potential tax savings that can result from owning community property. However, there are also challenges that couples must face in using community-property laws most efficiently. The second part of this article discusses these issues in greater detail.
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Fool contributor Dan Caplinger has tried living both with and without community-property laws and has settled on going without, at least for now. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't leave you out in the cold.