Is The Community Property Trust Act Right For Your Clients?
By: Stefan Dunkelgrun, Aloia, Roland, Lubell & Morgan, PLLC, Fort Myers, Florida
What is this new Community Property Trust?
In April of 2021, Florida added two sections to the Trust Code, effective as of July 1st, 2021. The two sections are the “Florida Uniform Directed Trust Act[i]” and the “Community Property Trust Act[ii]“.
The Community Property Trust Act allows a married couple to create a “Community Property Trust”, and any property added to that Trust will be deemed the community property of that married couple.
Why Is This Important?
There is a significant tax advantage give to Community Property, involving the step-up in basis.
When a single person passes away, his or her heirs receive a step-up in basis on any investments[iii]. For example, if a client bought stock in Apple in 1996, at $0.25 per share, and the client sold it today for $150.25 per share, the client would be taxed on the gains (the profit) of $150[iv]. However, if the client’s heirs receive the shares due to the client’s passing, for tax purposes it will be as if the heirs bought the shares at the value on the day the client passed away. So, if the client passed away on August 30th, the shares were worth $150.25, and if the shares were sold that day, the heirs would pay no tax whatsoever. Any time there is a step-up in basis the outcome is a reduced the tax bill.
Any property that is jointly owned, either as joint tenants or as tenants in common, receives a step-up only on the portion belonging to the decedent[v]. Imagine that a husband and wife own 100 shares. When the first spouse passes away, 50 shares receive a step-up in basis, and when the second spouse passes away, the other 50 shares receive a step-up in basis.
However, due to a quirk in the tax code[vi], “Community Property” gets a full step-up in basis at the death of each spouse, and therefore potentially provides significant tax advantages.
What are the different ways to jointly own property?
In the U.S., there are 5 ways a person can own property, two of which are only available in certain states.
- Sole Ownership. One person owns the property on his or her own, and doesn’t share it with anyone.
- Tenants in Common. Two or more people own a specific fraction of the property. The owners don’t need to own equal shares, so, for example, one person could own 90%, and two other owners have a 5% share each. Most importantly, each owner can sell his or her share or pass it along to his or her heirs.
- Joint Tenancy, with Rights of Survivorship. Two or more people own the property together. Again, the owners don’t need to each have equal shares. However, the key term here is “Rights of Survivorship”. What this means is that when one owner passes away, his or her share automatically belongs to the other owners – his or her heirs get nothing. If someone sells their share in a joint tenancy, it is automatically converted into Tenants in Common.
- Tenants by Entirety. This is a special form of joint tenancy that is only available for married couples. In this case, the property is treated as belonging to the married couple as a single unit – any actions involving the property need to be agreed upon by both spouses. One spouse cannot sell, give away, or borrow against the property unless the other spouse also agrees. Property that is Tenants by the Entirety cannot be claimed to satisfy one spouse’s debts. And, if one spouse passes away, the property automatically belongs to the other spouse. This provides special protections, and is available in 23 states.
- Community Property. This is a special form of joint ownership whereby property acquired during the marriage belongs equally to both spouses. Like Tenants by the Entirety, one spouse cannot sell the property without the other spouse’s permission, but unlike Tenants by the Entirety, creditors of one spouse can place a claim against the property. If one spouse passes away, he or she can leave his or her half of the property to his or her heirs. This form of ownership is available in 9 states.
So are clients better off with a Community Property Trust?
Not so fast. First, there are some drawbacks to Community Property. Depending on how your clients own the property now, their rights may change significantly (see the brief explanations of the different forms of ownership above). The drawbacks are significant enough that the statute requires a Community Property Trust to contain the following warning at the beginning of the Trust:
THE CONSEQUENCES OF THIS COMMUNITY PROPERTY TRUST MAY BE VERY EXTENSIVE, INCLUDING, BUT NOT LIMITED TO, YOUR RIGHTS WITH RESPECT TO CREDITORS AND OTHER THIRD PARTIES, AND YOUR RIGHTS WITH YOUR SPOUSE DURING THE COURSE OF YOUR MARRIAGE, AT THE TIME OF A DIVORCE, AND UPON THE DEATH OF YOU OR YOUR SPOUSE. ACCORDINGLY, THIS TRUST AGREEMENT SHOULD BE SIGNED ONLY AFTER CAREFUL CONSIDERATION. IF YOU HAVE ANY QUESTIONS ABOUT THIS TRUST AGREEMENT, YOU SHOULD SEEK COMPETENT AND INDEPENDENT LEGAL ADVICE. ALTHOUGH NOT A REQUIREMENT, IT IS STRONGLY ADVISABLE THAT EACH SPOUSE OBTAIN THEIR OWN SEPARATE LEGAL COUNSEL PRIOR TO THE EXECUTION OF THIS TRUST.
More importantly, your clients might not get the tax benefit that the Florida Legislature intends. Florida is not the first state to try this. Back in 1939, Oklahoma adopted a law that effectively allowed married couples to “opt-in”, to treat certain property as community property by filing an election[i]. The IRS challenged it, and the results were, to quote the Supreme Court “the State [does not have] any new policy, for it has not adopted… any legal community property system”[ii] – the Court stated that the provision was no different than a pre-nuptial or post-nuptial agreement.
Back in 1999, Alaska passed a Community Property Act[iii], which allows residents to elect to have community property, and allows non-residents to form a Trust that can elect Community Property. Tennessee followed with a Community Property Trust Act[iv] in 2010, which allows property contributed to a Trust to be deemed community property, and South Dakota did the same in 2016[v]. The laws in Tennessee and South Dakota are effectively the same as Florida’s new Community Property Trust Act.
So it works in other States?
Similar laws have been passed in other States, but that doesn’t mean it works. Laws passed by the various States cannot override federal law – for example, if a state were to pass a law stating that a chicken is now a duck, any federal laws that apply to chicken will still apply to the same birds that used to be known as chicken.
The IRS has provided guidelines for the tax treatment of Community Property in the 9 Community Property States[vi], and has specifically stated that the guidance does not address the Alaska, South Dakota, and Tennessee laws. In other words, the IRS does not accept those provisions – the ruling against the Oklahoma statute still stands, and the IRS will probably challenge the Alaska, South Dakota, and Tennessee laws when the time is right.
But it’s been 20+ years!
Yes, it has. However, that doesn’t mean anyone has been able to take advantage yet. Tax basis does not become an issue until (1) one of the two spouses passes away, and (2) the property that was contributed to a Community Property Trust is sold. Even then, the IRS does not scrutinize every income tax return, and they may be waiting for just the right case to challenge and invalidate the laws.
On top of that, there are potential technical pitfalls related to the gift tax that could accidentally be tripped up. While those are beyond the scope of this article, be aware that there can be real costs involved.
While 20 years is a long time, for this kind of statute, until there’s an actual ruling on the matter, caution is advised – there are real drawbacks and you might not get any benefit.
[i] Act of May 10, 1939, ch. 62, 1939 Okla. Sess. Laws 190 (codified as amended at Okla. Stat. sections 51-65 (1941)) (repealed 1945)
[ii] Commissioner v. Harmon, 323 US 44, 47 (1944)
[iii] Alaska Stat. Sect. 34.77
[iv] Tenn. Code Ann. §35-17
[v] SD Codified L § 55-17
[vi] I.R.S. Pub. 555 (Rev. March 2020)
Bio:
Stefan Dunkelgrun leads the Wills, Trusts, Estates and Probate practice at Aloia, Roland, Lubell & Morgan, PLLC. He has vast experience in high net worth and ultra-high net worth estate planning, developing asset protection solutions, drafting complex trusts, business succession planning, and tax reduction strategies. In addition to estate planning, Dunkelgrun has significant experience designing sophisticated insurance-based estate planning solutions such as premium finance platforms and offshore private placement products.
Dunkelgrun is admitted in Florida, Minnesota, New York and North Dakota, as well as U.S. Tax Court, and holds an M.B.A., and a J.D. from Fordham University.
