Community Property at Death
How is Community Property Treated At
Death?
The tax basis of all community property is adjusted (i.e.,
stepped-up) to its fair market value when one of the
spouses dies, even though only one-half is subject to
estate taxes. For joint tenancy with right of survivorship,
however, only the deceased spouse's one half interest is
"adjusted."
For example, if a married couple, Stanley and Iris, buy
securities as "joint tenants with rights of survivorship" for
$400,000, the IRS considers that each paid $200,000 for a
one-half interest. If Stanley later dies, Iris automatically
owns the entire account, and Stanley's one half of all the
securities in their portfolio are revalued as of the date of
his death. If the account was worth $1,500,000 when Stanley
died, then Iris is treated as if she paid $950,000 for the
securities -- computed by adding her share of the purchase
price ($200,000), to the value of Stanley's share when he died
($750,000).
In contrast, the IRS treats "community property" as if it were
owned completely by the deceased spouse, in applying this
special "adjusted basis" rule. (For other purposes, such as
computing estate taxes, only one-half of the value of community
property is counted.) Therefore, if Stanley and Iris bought
their securities as "community property" for $400,000 and
Stanley later died, leaving his share to Iris, the entire
account would be assigned a new "basis" at current fair market
value. Threrfore, Iris's basis in the securities becomes
$1,500,000.
The result is that if Iris decides to sell the "joint tenancy"
property for $1,500,000 shortly after Stanley's death, she
would realize a taxable capital gain of $550,000 (the
$1,500,000 sale price minus her $950,000 "adjusted basis,"
computed two paragraphs above). If the same account were held
as "community property," however, she would recognize no
capital gain, because her "adjusted basis" would be the same as
the sale price. Therefore, where spouses hold highly
appreciated assets, the community property form is more
favorable for capital gain tax purposes.
It is possible in some community property states for the
spouses to change their respective ownership rights in an
asset, from community property to separate property and
vice-versa, simply by executing a written agreement to that
effect. For example, in California, a couple with a joint
tenancy with rights of survivorship account may simply append a
note to their wills explaining that their intention is for
their possessions, no matter how registered, to be considered
community property. By doing this, the surviving spouse
receives a full step-up in basis after the first spouse's
death, while also retaining the convenience of holding the
property in joint tenancy.
Since accounts held as community property are subject to
probate, it might be advisable to hold community property in a
trust account or a Totten trust (payable/transfer on death
accounts), to avoid the probate process. Community property
with right of survivorship accounts are allowed in Arizona and
California.
| 
