In community property states, each spouse’s interest in the community property is subject to the claims of the other spouse’s creditors. If there is a judgment against the husband, all community property assets held by husband and wife are available to satisfy the judgment. On the other hand, the separate property of a spouse will generally not be subject to the claims of the creditors of the other spouse.
These rules provide some obvious opportunities to achieve a measure of asset protection. If community property is divided into equal shares of separate property of the husband and separate property of the wife, those separate property interests will not be available to satisfy the claims of the other spouse’s creditor. Generally, a living trust would be created for each spouse-for the estate planning benefits and to confirm that the marital property has been divided. Those in community property states can at least limit their potential exposure to a creditor’s claim to one-half of the marital property, rather than all of the marital property, by creating this type of division.
The primary drawback of this technique is that a division of community property into separate property trusts may be disadvantageous from an income tax standpoint. All property held as community property receives a stepped-up basis on the death of the first spouse. For example, a husband and wife buy a property during their marriage for $50,000 that is later worth $100,000. If they sell the property, they will have a gain of $50,000 and will pay taxes on that amount. Suppose that instead of selling, the property is held until the time the first spouse dies. All community property now receives a new tax basis equal to its value as of the date of death-$100,000 in this example. Therefore, if the property is held until the death of the first spouse, all taxable gain is eliminated.
This favorable situation does not occur when a husband and wife hold separate property. In this situation, only the deceased spouse’s interest in the property receives the stepped-up basis. In the above example, if the property were held one-half each by Husband and Wife, only the interest of the deceased spouse would receive the new basis. This would result in a $75,000 basis, and a $25,000 gain, if the surviving spouse sold the property for $100,000.
If you hold community property that has substantially appreciated in value, it probably would not be advisable to divide the property into separate shares and thereby lose out on the significant tax savings that can otherwise be achieved. Alternative methods of asset protection should be explored.