23 Apr 2012

Community property is a marital property system that defines what assets are jointly owned by spouses during their marriage. California applies its community property laws to registered domestic partners as well as to married spouses. For purposes of this article, references to spouses are also references to registered domestic partners unless stated otherwise. The determination of what assets are community property assets becomes relevant in several situations, including:

1.       Division of assets in a divorce proceeding.

2.         Disposition of a deceased spouse’s assets upon death.

3.         Determining the liability of community property assets and separate property assets for debts of the spouses.

4.         Income tax basis adjustment to community property assets at death (this does not apply to registered domestic partners).

California’s Definition Of Community Property And Separate Property.  California is one of nine community property states in the United States, which includes: Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Each state has its own definition of what constitutes community property. California law provides that except as otherwise provided by statute, all property, real or personal, wherever located, acquired by a married person during the marriage while living in California is community property. Assets that are not community property assets are considered the separate property assets of one of the spouses.  Separate property assets of a married person include:

1.         property owned by the person before marriage;

2.         property acquired by a person after marriage by gift, bequest, devise or descent;

3.         rents, issues and profits of separate property assets; and

4.         earnings of a spouse while living separate and apart from the other spouse are separate property earnings.

Income Tax Basis Of Community Property Assets Upon The Death Of A Spouse.  For income tax purposes, assets held as community property on the death of one spouse receive an income tax basis adjustment to fair market value as of that date. This is typically referred to as a “step-up in basis” when an asset has appreciated in value since the date it was originally acquired. For example, Joe and Mary Baker own a community property asset that they purchased for $100 (its income tax basis).  Joe dies and Mary survives him. The fair market value of the community property asset on Joe’s death is $1,000.  As such, this asset receives a new income tax basis of as of Joe’s date of death of $1,000.  If, however, Joe and Mary had owned this same asset as joint tenancy with right of survivorship, it would only have received a step-up in income tax basis as to Joe’s half of the asset, or a new income tax basis of $550 for the entire property ($450 (1/2 of the appreciation ($900)) + $100 (existing basis)). If that same asset was Mary’s separate property asset, it would receive no income tax basis adjustment on Joe’s death. As noted, appreciated community property assets, unlike joint tenancy assets, separate property assets, and quasi-community property assets (discussed below), receive favorable income tax treatment upon the death of a spouse.  Basis adjustments do not apply to community property owned by registered domestic partners.

Quasi-Community Property. There is a third type of property in California known as “quasi-community property.” Quasi-community property is defined as California real property and personal property, wherever located, acquired by either spouse while living in another state which would have been considered community property if the spouse who acquired the property had been domiciled in California at the time of its acquisition. The characterization of quasi-community property is significant upon divorce and death while the spouses are domiciled in California.

Quasi-community property does not receive the same income tax benefits as community property (described above) regarding basis adjustments upon death. Quasi-community property is treated the acquiring spouse’s separate property asset for income tax basis purposes. If you have quasi-community property, you should consider the benefit of executing a transmutation agreement to transmute all quasi-community property to community property in order to obtain a new income tax basis upon the death of a spouse.

Gifts.  Community property assets and separate property assets are treated differently for gifting purposes under California law. For gifts of community property assets, both spouses must consent to make the  gifts.  However, for separate property assets, the spouse owner of separate property assets does not need the consent of the other spouse.

Commingling Funds. California law presumes that assets acquired by a married couple during the marriage are community property assets, unless there is a statutory exception to the community property rule identifying the assets as separate property assets (e.g., assets received by gift, devise or descent). Things get tricky when community property assets and separate property assets are commingled.  For example, if one spouse’s salary (a community property asset) is added to the joint checking account that has the other spouse’s inheritance (a separate property asset), the assets have been commingled. Separate property assets that are commingled with community property assets will be considered community property unless the separate property assets can be traced back to their original separate property sources. Accordingly, it is important, particularly for the spouse who owns the separate property assets, to segregate separate property assets from community property assets to avoid having to trace back to the source of the assets.

Transmutation.  A married couple may agree to transmute or change community property into separate property, or separate property to community property as long as it is done in writing and has all of the elements required by California law. In addition, a married couple may define their property rights, outside of the confines of community property defined rights, through a prenuptial or postnuptial agreement. Many people today enter prenuptial agreements before walking down the aisle.  However, as we know from the much publicized Barry Bonds divorce matter and the Frank and Jamie McCourt divorce matter, even if you have a prenuptial agreement, there still may be a fight in divorce court over the assets. But, the court will uphold a properly negotiated and drafted prenuptial/postnuptial agreement to protect the agreed upon marital property rights for the marriage. Remember, in the immortal words of rapper Kanye West, “if you ain’t no punk, holla we want prenup, WE WANT PRENUP! Yeah!” Gold Digger (2005).

Debts.  Debts incurred by a spouse before marriage are characterized as separate debts.  Generally, debts incurred by a spouse after marriage are community debts.  However, a debt incurred during marriage (but before separation) that is not for the benefit of the community is a separate debt.  Characterizing a debt as “separate” or “community” defines what assets may be used to satisfy these debts.  On the death of a spouse, his or her separate debts are paid from his or her separate property assets.  Community debts are paid from both spouses’ community and quasi-community property assets.  A deceased spouse’s funeral expenses and last-illness expenses are the sole responsibility of the deceased spouse’s estate and must be paid from the deceased spouse’s assets.

It is important to be aware of the rules that determine the character of property as separate or community. As summarized above, the character of your assets has significance regarding taxes, creditors’ rights, gifts, divorce and death.  Furthermore, it may be appropriate for you to have a prenuptial/postnuptial agreement defining your marital asset rights outside of the scope of the community property laws.  Also, it is important to be careful not to unintentionally convert separate property assets into community property assets by commingling.

If you would like to discuss this or other trusts and estates issues, please contact the attorneys at Drucker Law Offices, 468 North Camden Drive, 2nd Floor, Beverly Hills, CA 90210, 310.285.5375 Tel, 310.444.9754 Fax, www.druckerlaw.com

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