Although we don’t give legal or tax advice, we ask each new client who walks in the door if they have talked to their attorney about the benefits of Alaska’s community property law. Our guest blog this week is by Steven O’Hara of Bankston, Gronning, O’Hara, P.C. Steve was present as Tony Knowles signed this act into law along with our founder Dave Rose. We are so honored to have his insights today.
The Community Property Advantage By Steven T. O’Hara
Since 1998 Alaska law has provided community property as an alternative form of ownership for married couples. In order to create community property under Alaska law, a couple must enter into a written “community property agreement” or a written “community property trust” (AS 34.77.030., .090, and .100). These are defined terms with specific requirements, and thus a couple will not have community property under Alaska law by default. The Internal Revenue Service has not officially recognized community property created under Alaska law as community property for federal tax purposes. Indeed, in its primer on the tax aspects of community property, the IRS uses quotation marks in distancing itself from Alaska law. The IRS states:
This publication does not address the federal tax treatment of income or property subject to the “community property” election under Alaska state laws. (Publication 555 (Revised January 2014), Community Property, Department of the Treasury, Internal Revenue Service, at 2.) As a practical matter, I believe accountants routinely treat Alaska community property on federal tax returns as community property, helping Alaskans reduce their income taxes. But be sure to discuss this subject with a competent tax advisor should you have Alaska community property. The option to create community property under Alaska law may be the opportunity to reduce potential income taxes. I call this possibility the “community property advantage.”
Recall that “basis” is used in determining gain or loss from the sale or other disposition of property (IRC Sec. 1001 and 1011). If a client purchases property for $10,000, her basis in that property is $10,000 (IRC Sec. 1012). If she then sells the property for $100,000, her taxable gain is $90,000, which is the consideration received in excess of basis. Also recall a so-called “stepped-up basis” to fair market value can be obtained on a transfer at death (IRC Sec. 1014). By the same token, if fair market value is below basis, a step-down in basis is also possible on a transfer at death.
If property has appreciated in value, community property can be beneficial in that both halves obtain a step-up in basis, whereas with joint property only one-half gets a step-up. By way of illustration, consider a husband and wife (both U.S. citizens) who own a share of stock as joint tenants with right of survivorship. They purchased the stock for $10,000, so this is their basis. The fair market value of the stock is now $100,000. The husband then dies. Here the surviving spouse will obtain a basis of $55,000 in the stock. This result occurs because half of the stock is considered included in the husband’s gross estate for federal estate tax purposes (IRC Sec. 2040(b) and 1014(b)(9)). This half is considered to have a fair market value of $50,000, since as we said the fair market value of the stock is $100,000 (IRC Sec. 2040(b)(1)). The surviving spouse’s basis in her half (which is not considered included in her husband’s gross estate) is $5,000 — that is, half of the couple’s original purchase price of $10,000. So the surviving spouse’s new basis in the stock is her original basis on her half (i.e., $5,000) plus the stepped-up basis in the half considered to have passed from her husband (i.e., $50,000), thus totaling $55,000. If the surviving spouse then sells the share, she would have $45,000 of gain. With the 3.8% Medicare surtax, it is possible this gain could generate a 2015 federal income tax liability of nearly $11,000 (IRC Sec. 1 and 1411). By contrast, suppose the same stock was acquired by the couple with community property and the couple maintained the character of the stock as community property. Suppose further that before dying the husband executed a Will giving his half in the stock to his wife, should she survive him. Under such circumstances, the surviving spouse would obtain a basis of $100,000 in the stock. Then the surviving spouse could sell the share at absolutely no tax cost, a possible savings of as much as $11,000 in income tax. In other words, the husband’s half of the community property passes through his estate as separately owned and thereby acquires a step-up in basis (IRC Sec. 1014(b)(1) and 2033). In addition, and what is peculiar only to community property, the surviving spouse’s half is deemed by statute to have passed from her husband and thus also gets a step-up in basis (IRC Sec. 1014(b)(6)).
Community Property can equalize assets between spouses and equalizing estates can save taxes. It is possible not only to save income taxes with community property, but also gift tax, estate tax, and generation-skipping transfer tax. Suffice it to say that funding gifts or trusts by two spouses can lower wealth transfer taxes as compared with funding gifts or trusts by only one spouse. Once it has been identified, community property should be preserved by segregating it from separate property and by maintaining records that will allow for tracing the community property from its disposition — including by Will or Living Trust — back to its acquisition. A premium should be placed on the maintenance of such records, particularly when clients move with community property from one jurisdiction to another. Community property is a good example of the rule in estate planning that each of a client’s assets should be analyzed from a local-law and tax standpoint. The question to consider is, what opportunity (or problem) is inherent in the ownership of the asset? Community property is not for everyone despite the possible tax savings.
Nothing in this article is legal or tax advice. Non-lawyers must seek the counsel of a licensed attorney in all legal matters, including tax matters. Lawyers must research the law touched upon in this article.
Copyright 2015 by Steven T. O’Hara. All rights reserved.
At APCM Wealth Management for Individuals we know that investments are only one piece of your financial picture. That is why we work with your attorney, CPA and insurance professional to give you peace of mind.