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Estate planning tailored to your state: Why one size doesn't fit all between community property and common law

by Legacy Plan
February 8, 2024

Estate planning is profoundly influenced by the legal framework of the state where an individual resides. The estate planning process involves making arrangements for the management and distribution of a person's estate after their death, and its complexity is heightened by the variations in legal systems across states. A key distinction in the United States lies between community property states and common law states, each having its unique approach to asset ownership and distribution. Understanding these differences is not just a legal formality but a practical necessity, as they directly impact how assets are managed, distributed after death and the legal ramifications for surviving family members.

Understanding community property states

In community property states, the foundational principle is that all assets and debts acquired during the marriage are jointly owned by both spouses, regardless of who earned or acquired them. This includes wages, property bought during the marriage and debt incurred. The states that follow this principle are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In these jurisdictions, upon the death of one spouse or in the event of a divorce, the marital property is typically divided equally. However, separate property, which includes assets acquired before marriage or those received as gifts or inheritances, remains with the individual spouse. This clear demarcation between marital and separate property in community property states simplifies ownership issues but also necessitates careful planning to ensure that each spouse’s estate planning objectives are met.

Understanding common law states

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In contrast, common law states adopt a more individualistic approach to property ownership. Here, the asset belongs to the person under whose name it is registered or who has acquired it. This means that marital assets are not automatically co-owned. Instead, each spouse’s separately owned property, unless jointly titled or commingled, remains their own and is not automatically subject to division upon death or divorce. This system, followed by the majority of the states, offers greater autonomy in asset control but requires meticulous planning to ensure that the distribution of assets upon death aligns with personal wishes, especially in the absence of a will or trust.

Estate planning in community property states

Estate planning in community property states centers around understanding and leveraging the joint ownership of assets. Spouses must consider how they title their assets and the implications of this joint ownership. For example, the inclusion of one spouse's name on the title of a property acquired before marriage can convert it into community property. Couples might opt for prenuptial agreements to clarify what should be considered separate property. Estate planning in these states often involves balancing the simplicity of equal asset division with the need to accommodate individual preferences and circumstances.

Estate planning in common law states

In common law states, the individual ownership model necessitates a more nuanced approach to estate planning. Here, the focus is on explicitly stating asset distribution wishes through wills and trusts. Since assets are not automatically considered jointly owned, the absence of clear legal documents can lead to unintended asset distribution that may not reflect the deceased’s desires. Estate planning in these states involves carefully designating which assets are to be shared and which are to remain separate, often necessitating more detailed legal documentation.

Intestacy in community property states

In the absence of a will and intestacy, community property states have default rules that typically divide the marital assets equally between the surviving spouse and children. This can lead to straightforward scenarios when dealing with jointly owned marital property but can get complicated for separate properties, especially if the deceased spouse’s wishes were not clearly documented.

Intestacy in common law states

In common law states, dying without a will (intestate) means that the state’s intestacy laws will determine how assets are distributed, which may not align with the deceased’s intentions. These laws vary but generally prioritize the surviving spouse and children, though the specifics can depend heavily on documented asset ownership. The absence of a will in these states can thus lead to complex legal challenges and distributions that may not reflect the deceased’s wishes.

In short, understanding the legal nuances of estate planning in both community property and common law states is critical for ensuring that assets are distributed as intended after death. The choice of state law can significantly impact estate planning strategies, making it essential for individuals to seek competent legal advice tailored to their specific situation and state regulations.

Inheritance tax implications comparison

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Navigating the nuances of inheritance tax implications is a pivotal aspect of estate planning, and these implications vary significantly between community property states and common law states. Understanding these differences is crucial for effective estate planning, as they can have a substantial impact on the amount of tax owed and the overall value of the estate passed on to heirs.

Tax implications in community property states

One of the most notable tax benefits in community property states is the "double step-up in basis." Upon the death of one spouse, the cost basis of the entire property, both the deceased's and the surviving spouse's portions, is stepped up to the market value as of the date of death.

This step-up can significantly reduce capital gains taxes if the surviving spouse decides to sell the property. For example, if a couple bought a house for $100,000 that's worth $500,000 at the time of one spouse’s death, the entire house's basis steps up to $500,000. If the surviving spouse sells the house later, the capital gains tax would only apply to the increase in value after the first spouse's death.

In addition to the step-up in basis, community property states also provide certain advantages when it comes to estate taxes. Assets passed to the surviving spouse are typically not subject to estate taxes until the death of the second spouse, allowing for potentially significant tax deferral.

Tax implications in common law states

In common law states, only the deceased's portion of the property receives a step-up in basis. Using the same example as above, if only half of the $500,000 house belonged to the deceased, then only $250,000 (representing the deceased’s half) would receive a step-up in basis. This could result in higher capital gains taxes compared to community property states if the surviving spouse sells the property.

In common law states, estate tax planning requires more strategic consideration. Since assets are individually owned, it’s important to plan how they are titled and passed on to minimize the tax burden. This might involve setting up trusts or other legal mechanisms to manage how assets are distributed and taxed.

Common law states also require careful consideration of gift taxes. Transferring property between spouses or to heirs might trigger gift taxes, which can impact the overall tax efficiency of an estate plan. This requires careful coordination and planning to avoid unnecessary tax liabilities.

The differences in tax implications between community property and common law states can have profound effects on the overall value of an estate and the tax burden on heirs. In community property states, the double step-up in basis offers a significant advantage in reducing capital gains taxes, while common law states require more intricate planning to achieve tax efficiency. These differences underscore the importance of tailoring estate planning strategies to the specific legal framework of the state, ensuring that one’s estate is managed and distributed in the most tax-efficient manner possible. As always, consulting with a tax professional or estate planner familiar with state-specific laws is crucial in navigating these complex tax landscapes.

Case studies and real-life examples

The complexities of estate planning in community property versus common law states are illuminated by examining real-life cases. These examples underscore how the legal system can significantly impact asset distribution, tax implications and potential legal disputes.

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  • The estate of a celebrity couple in California. In a high-profile case from California, a community property state, a celebrity couple amassed a considerable fortune during their marriage. Upon the death of one spouse, the entire estate was subject to a double step-up in basis. This meant that the surviving spouse could sell properties and investments with minimal capital gains tax. However, there were complications due to certain assets (like a vacation home and an art collection) acquired by one spouse before marriage. These were considered separate property, leading to disputes among heirs about their division. This case highlights the importance of clear documentation and estate planning in community property states, especially concerning separate and community assets.

  • An estate dispute in New York. A prominent businessperson in New York, a common law state, passed away without a clear will. The estate included a mix of individually owned assets and assets co-owned with their spouse. Due to the lack of clear instructions, the distribution became contentious. The spouse claimed a right to certain assets, believing them to be marital property. However, since these assets were only in the deceased’s name, they were distributed among all legal heirs, including children from a previous marriage. This case underscores the necessity of specific estate planning in common law states to ensure assets are distributed as intended.

  • Tax implications in a community property state. A tech entrepreneur in Washington state, which follows community property laws, passed away, leaving a large portfolio of stocks and real estate. Due to the community property laws, the entire estate received a step-up in basis, significantly reducing the capital gains tax for the surviving spouse upon the sale of these assets. This case highlights the tax advantages in community property states, which can lead to substantial savings for the surviving spouse, particularly with high-value assets.

  • An inheritance dispute in Florida. In Florida, a common law state, a family faced a dispute over an inheritance. A parent had remarried, and their new spouse laid claim to certain assets that the children from the first marriage believed were solely their parent's. Due to the lack of clear documentation proving separate ownership, the court had to intervene to determine the asset distribution. This scenario illustrates the potential for disputes in common law states, particularly concerning separate versus marital property.

These case studies and real-life examples illustrate the critical differences in how estate planning and asset distribution are approached in community property versus common law states. They highlight the need for comprehensive estate planning tailored to the legal specifics of each state. Whether it’s managing tax implications or clarifying the ownership of assets, these examples underscore the importance of clear documentation, legal advice and foresight in estate planning.

Conclusion

The intricate process of estate planning significantly varies between community property and common law states, making a one-size-fits-all approach ineffective. Each system's unique characteristics profoundly impact how assets are managed, distributed after death, and the legal outcomes for surviving family members. The examples and case studies discussed in this article underscore the necessity of understanding these differences and the importance of tailored estate planning strategies.

In community property states, the joint ownership principle offers simplicity in understanding marital asset division but requires careful planning for separate properties. Estate planning in these states often involves navigating the fine line between the straightforward division of marital assets and the complexities of individual property.

Conversely, common law states require meticulous planning to ensure that assets, whether individually or jointly owned, are distributed according to personal wishes, especially in the absence of a will or trust. The individual ownership model in these states offers greater control but necessitates detailed legal documentation to ensure fair and intended asset distribution.

The case studies from both systems illustrate the varied challenges families can face, from tax implications to inheritance disputes. These real-life scenarios highlight how the legal system of a state can dictate estate planning strategies, emphasizing the need for specialized knowledge and legal guidance.

Moreover, the tax implications in each system – the double step-up in basis in community property states versus individual asset considerations in common law states – further illustrate the need for strategic planning. Understanding these tax nuances can lead to significant savings and a more effective transfer of assets to heirs.

How do I create an estate plan?

There are numerous options and scenarios to consider when developing an estate plan that protects your legacy and achieves your objectives, and important decisions should be made with the advice of qualified lawyers and financial experts. Membership with Legacy Assurance Plan provides members with valuable resources and guidance to develop comprehensive estate plans that take life's contingencies into consideration and leave a positive impact for generations to come. Legacy Assurance Plan members also receive peace of mind that a team of trusted, experienced professionals will assist them in developing legal, financial and tax strategies that will meet their needs today and for years to come through periodic reviews.

This article is published by Legacy Assurance Plan and is intended for general informational purposes only. Some information may not apply to your situation. It does not, nor is it intended, to constitute legal advice. You should consult with an attorney regarding any specific questions about probate, living probate or other estate planning matters. Legacy Assurance Plan is an estate planning services company and is not a lawyer or law firm and is not engaged in the practice of law. For more information about this and other estate planning matters visit our website at legacyassuranceplan.com.

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