What Is Community Property?

When you’re creating a trust, if you’re married, you may hear the terms “community property” and “separate property” throughout the process. It’s important to know what elements of your assets are considered community property, because this changes what happens to your assets when you die or become incapacitated.

Community Property vs. Separate Property

Community property is any assets you acquired from your labor during your marriage together. Separate property is any assets you owned before your marriage, and any assets you receive as a gift or inheritance during your marriage.

(One important note: these are simplified explanations of the default definitions of community property and separate property. A married couple can always agree to change the rules and definition of what assets are considered separate property vs community property by entering into a prenup or postnup.)

Sounds simple enough, right? But things can get tricky if you start commingling assets.

Let’s say that you get a financial gift from your mom, and then you deposit that gift into a joint account you hold with your spouse. You and your spouse start using some of the funds in that joint account to invest in the stock market, and that stock value appreciates. Then you spend cash from that joint account, and in time it becomes less clear what part of the account is the gift from your mom (your separate property).

Or, let’s say you purchased a house before you were married, which would mean the house is separate property. You start renting out the house. During your marriage you stop working, and all your time is committed to being a property manager of that property. You decide to start renting it out for short-term and vacation rentals, so you start remodeling the property to increase rent. The rental income may be considered community property if property management is your job. A portion of the appreciation in the house value is arguably community property as well since the increase in value is a result of your labor during marriage.

None of this really matters all that much when you’re married and alive … but if you get a divorce, or when you die, then things get complex.

We’re not divorce experts, so we’ll just say this: if you do have commingled assets and you’re getting a divorce, then it’s likely that your attorneys will need to hire forensic accountants to trace who owns what. Please consult a licensed divorce attorney for more information.

When you die, the question of what is community property or separate property becomes important because the designation determines which spouse can control who benefits from the assets. Community property and separate property also have different income tax benefits at death.

Control

When one spouse dies, the deceased spouse can write the rules on what happens to their half of the community property and the surviving spouse remains in full control of their half of the community property. If the deceased spouse does not specify what will happen with their half of the community property, then the probate court will follow California law and the surviving spouse will inherit the deceased spouse’s half of community property.

Each spouse controls 100% of their own separate property. If the deceased spouse does not specify what will happen to their separate property, California law says the surviving spouse will inherit 50% of the deceased spouse’s separate property and the other 50% will go to their children, then parents, then siblings, then grandparents, then aunts and uncles, then cousins.

To summarize, you can write the rules on what happens to your half of community property and your separate property.

Income Taxes

When you die, the “tax basis” of your assets is adjusted to fair market value on your date of death, which means if your trust manager sells assets shortly after your death, there will not be any capital gain tax. 100% of your community property assets will receive a basis adjustment. Your separate property assets will also receive a basis adjustment, but your surviving spouse’s separate property will not receive a basis adjustment.

For example, Ross and Rachel are married. They own a condo that was purchased for $500,000 in the 1990s. At Rachel’s death, the condo is worth $1,000,000 and the tax basis is adjusted to $1,000,000. If Ross sells the condo a year later for $1,200,000, then Ross is paying capital gain tax on $200,000 of gain. If that same condo is Ross’s separate property, then at Rachel’s death there is no adjustment of the tax basis, and when he sells Ross would pay capital gain tax on $700,000 of gain ($1,200,000 minus $500,000).

What happens if I don’t know?

Creating a joint trust and transferring assets to the trust will not automatically make your assets community property or separate property. So, if there is a divorce, you will each still have the opportunity to trace assets.

If you are both clear that a particular asset is one spouse’s separate property, then please let us know so we can guide you on how to title that separate property asset.

We’re always here to help. Reach out to us at hello@trustduet.com at any time.