Julia C. Rice, LL.M. (Tax)
Attorney, Law office of Julia Rice
Lake Oswego, Oregon
In today’s mobile society, effective estate planning requires an appreciation of the intersection of state laws. This is particularly true when it comes to clients who have moved to Oregon from community property states such as California and Washington.
As this article explains, Oregon estate planners should investigate whether clients have lived in community property states and have community property assets. Clients who come to Oregon with community property assets can achieve significant tax savings through careful planning.
Community Property States. Nine states have community property laws: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.[1] Given that Oregon, a common-law property state, is surrounded by community property states, estate planners in Oregon have a high likelihood of representing clients who have moved here from a community property state.
Specific laws vary in community property jurisdictions. For example, some community property states count the income from separate property as separate property, whereas other states designate the income as community property.
Community Property Defined. In Oregon and other common law property jurisdictions, assets acquired during the marriage are generally considered an individual’s separate property.
In community property states, by contrast, each spouse is deemed to own an undivided one-half interest in all property acquired during the marriage. This presumption typically does not apply to property acquired prior to the marriage or by gift or bequest during the marriage.
In general, a decedent’s interest in community property does not pass automatically to the surviving spouse. Some jurisdictions, however, have modified traditional community property principles to provide for assets to transfer through a right of survivorship.
Uniform Disposition of Community Property Act. To address the differences between property law systems, Oregon has adopted the Uniform Disposition of Community Property Rights at Death Act (the “Act”).[2] The Act preserves each spouse’s rights in property that was community property before the move to a non-community property state, unless the married couple severed or altered their community property rights.[3] ORS 112.715 provides that the Act covers “all or the proportionate part of that [real or personal] property acquired with the rents, issues, or income of, or the proceeds from, or in exchange for, [property acquired as or which became, and remained] community property under the laws of another jurisdiction; or traceable to that community property.”
The Act contains two rebuttable presumptions for determining whether property falls under its ambit. First, the Act is presumed to apply to any property acquired during a marriage while living in a community property jurisdiction. Second, the Act is presumed to not apply to any real property located in Oregon and personal property wherever situated if such property was acquired during the marriage in a non-community property jurisdiction and title was taken in a form that created rights of survivorship.[4] Therefore, if a married couple moves to Oregon and uses the proceeds from the sale of community property to purchase property here as joint owners with survivorship rights, the couple is presumed to have acquired the property as non-community property.[5] For reasons discussed next, couples may instead wish for the property to be treated as community property.
Full Step-Up in Basis. For estate planning clients, one of the most significant benefits of identifying and preserving community property status for real and personal property is the ability to obtain a full step-up in basis when the first spouse passes away. IRC 1014(b)(6) provides a special basis rule for community property states. Upon the death of the first spouse, the surviving spouse receives a basis step-up in both the decedent’s one-half interest in community property as well as the surviving spouse’s one-half interest.[6] A subsequent sale of the property would reflect a basis equal to the fair market value of the entire property at the decedent’s death, which can save the surviving spouse substantial capital gains taxes.
Further, if the asset is depreciable, the step-up in basis allows the surviving spouse to obtain additional depreciation deductions starting from the fair market value of the property as of the decedent’s date of death. These deductions can be used to offset the surviving spouse’s income from other sources.
Additional Tax Benefits. Additional tax benefits exist for property that retains its community property status. IRC §2040 does not apply to community property, which means that a fractional interest discount can be applied if the property qualifies as community property.[7] Married couples can also gift-split their community property without the need to file a gift tax return. Further, under community property laws spouses can form an LLC as a disregarded entity, whereas under Oregon law they would be taxed as a partnership rather than as a disregarded entity.[8]
Planning with Community Property. Attorneys can employ several strategies to ensure clients’ property will maintain community property status. These strategies include properly titling assets, creating community property trusts and drafting property agreements to enable tracing of funds from community property.
Attorneys should ascertain in initial meetings whether clients have lived in a community property state and, if so, whether they were married while they lived there. Without this inquiry it is possible Oregon attorneys may unintentionally transform community property into a different ownership form without recognizing the benefit of preserving that community property status.
In addition to inquiring about whether a client may have community property, estate planners should examine the status of each asset that originated in the community property jurisdiction. Married couples commonly make the mistake of converting their community property into jointly held property with right of survivorship. Unless the couple enters into a spousal or other written agreement confirming their intent to preserve the character of the property, they will lose the tax advantage available to them.
Tracing. Given the broad scope of ORS 112.715, Oregon estate planners have substantial planning opportunities even if the clients say they no longer have any property located in the community property jurisdiction. For example, an Oregon attorney representing clients who have recently moved from California should determine whether they plan to use the proceeds from the sale of their California residence to purchase an Oregon home. If so, the attorney can have the clients execute a community property trust with the husband and wife as trustees.
Community property trusts are revocable living trusts that preserve the community property characteristics of property contributed to the trust. Revenue Ruling 66-283 confirms that such trusts will maintain the community property character of the trust property for income tax purposes.[9] Employing this technique before a couple retitles their community property in Oregon with survivorship rights will avoid the presumption in ORS 112.725(2) against community property status.
If the couple can trace the funds used to purchase the home from their community property and preserve the character of the property as discussed above, the second spouse will receive a full step-up in basis in the home rather than a step-up in basis only for the decedent’s share.
Clients should also avoid commingling community property and common law property so they can trace assets to community property funds. They should keep records to identify and trace property, including the source of funds used to acquire or improve property. Further, keeping separate accounts for community property and separate property is advisable.
Testamentary control. In addition to tax savings, couples may have other planning reasons for maintaining the community property nature of their assets. Since each spouse is deemed to own a one-half interest in community property, the deceased spouse’s share can pass by will or trust to any person, not solely to his or her spouse. A spouse in a second marriage, for example, could direct his or her one-half interest to pass to children from a first marriage rather than to the surviving spouse.
In Oregon, if a couple owns property as joint tenants with right of survivorship or as tenants by the entirety, the spouse who dies first cannot make such a designation.[10] Rather, the decedent’s share would pass directly to the surviving spouse. Preserving community property status for assets may help couples in a second marriage ensure that one-half of the property will remain subject to each spouse’s testamentary control.
Community Property & Probate. The Act can significantly impact the disposition of property at death. As noted above, ORS 112.735 provides that spouses only have testamentary-disposition rights over one-half of any property to which the Act applies. Similarly, for intestate estates, only the decedent’s one-half of the community property will pass pursuant to Oregon’s laws of intestate succession. And, a surviving spouse cannot assert elective share rights against the decedent’s one-half of the property subject to the Act.[11] Thus, attorneys must take care to determine the correct status of all assets that the decedent owned or co-owned. Whether assets count as community property under the Act could determine whether they will pass as part of the decedent’s estate.
Neither the personal representative nor the court has a duty to determine whether the Act applies to the decedent’s property.[12] The duty arises only if the surviving spouse or the spouse’s successor in interest makes a written demand.[13] The personal representative can then institute an action to perfect title to the property.[14] A failure by an heir, devisee or creditor to make this demand can affect the personal representative, heir or devisee’s ability to perfect the surviving spouse’s title to the property.[15]
Property Agreements. Attorneys must also determine whether any spousal agreements or waivers exist that will affect the community property rights of the couple. Agreements that may affect the community property status of property include prenuptial agreements and community property agreements.
Example. Clients meet with an Oregon estate planning attorney. They have lived in Oregon for less than a year, and they lived in California for twenty-eight years before that. They have been married twenty years. They bought a home in California fifteen years ago and have recently sold it. They now own a home in Lake Oswego, which they use as their primary residence. They plan to use the funds from the sale of their California home to purchase a vacation home in Sunriver.
In this case, the attorney should consider a community property trust for the clients. This mechanism will allow the clients to cleanly trace the source of funds for the Sunriver property and allow the property to be characterized as community property. The clients must carefully maintain all records tracing the use of their community property funds to purchase the Sunriver residence.
The wife later came to see the attorney years down the road after her husband had passed away. If the Sunriver residence was recognized as community property under the Act, assuming the property appreciated in value from the date of purchase until the date of death of the husband, the wife’s tax basis would reflect a full step-up rather than a one-half step-up.
For example, if the couple paid $500,000 for the Sunriver home from their community property funds and the property was purchased and held in a trust that preserved the community property status of the new property, when the husband died, if the fair market value of the property was $1,000,000 the wife’s income tax basis of the property would be adjusted to the value of the property at the husband’s death, or $1,000,000. Thus, if the wife sold the Sunriver residence at its market value of $1,000,000, she would not realize any capital gains tax on the sale.
If the couple had converted the property to joint ownership with a right of survivorship or the property had otherwise not been recognized as community property, the tax outcome would be significantly different. Upon the husband’s death, the wife would receive a step-up in basis only for the husband’s one-half interest in the jointly owned property. Thus, she would have a new tax basis in the property of $750,000 rather than $1,000,000. If the wife sold the property for $1,000,000, she would pay capital gains tax on the $250,000 difference.
In 2015, Oregon ranked third for the highest capital gains tax rates in the nation.[16] The highest combined state and federal capital gains tax rate for Oregonians was 31%.[17] Therefore, the wife could have paid as much as $77,500 in avoidable capital gains tax.
Summary. Attorneys must carefully examine the character of property held by clients and their desires for their property. Estate planners can use a variety of methods to preserve the character of community property. To use the tracing rules under the Act to their clients’ advantage, attorneys can use community property trusts and community property agreements. Further, attorneys must help clients understand the risks under Oregon law of retitling property with survivorship rights and commingling community property with non-community property. By understanding the differences between the state property laws, attorneys can skillfully guide clients through the planning process while using the property laws to their advantage.
[1] Alaska and Tennessee have adopted optional community property systems.
[2] ORS 112.705-112.775.
[3] ORS 112.775.
[4] ORS 112.725.
[5] Id.
[6] IRC 1014(b)(6).
[7] Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982).
[8] Rev. Proc. 2002-69.
[9] Rev. Rul. 283, 1966-2 C.B. 297.
[10] However, the couple can employ other estate planning strategies to address this potential issue.
[11] ORS 112.735.
[12] ORS 112.745.
[13] Id.
[14] Id.
[15] Id.
[16] https://ballotpedia.org/Tax_policy_in_Oregon.(Ballotpedia, 2015)
[17] Id.