Community Property Opt-In Trusts Explained for Advisors

Welcome to Talking T&E for Advisors, where Trusts & Estates Editor in Chief Susan Lipp and Jamie Hopkins, chief wealth officer at Bryn Mawr Trust, take seemingly complex estate planning issues and break them down for financial advisors.

In this video, they discuss community property opt-in trusts.

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Read the full raw transcript below:

Susan Lipp: Hi, I’m Susan Lipp, editor-in-chief of Trusts & Estates, and I’m speaking with Jamie Hopkins, CEO of Bryn Mawr Trust Advisors LLC and chief wealth officer at Bryn Mawr Trust. Today, we’re discussing community property opt-in trusts based on an article that was written by Craig Hersch in the May issue of Trusts & Estates. So, just for a little background, some common law states enact statutes that allow spouses to elect community property treatment through a trust structure. Doing that helps reduce capital gains because community property states treat the surviving spouse’s one-half interest in community property as having been acquired from the decedent, provided that at least one-half of the whole is included in the decedent’s gross estate, permitting a full fair market value basis adjustment at the first step. We’re going to get into that a little bit more. Jamie’s going to discuss some aspects of that, but first to start us off, Jamie, if you could explain common law versus community property.

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Jamie Hopkins: Yeah. Well, that was a great intro. I think we got a lot there. I think we got some of the code section in there that determines it, too. So, one of the starting points of this whole conversation—great article. If you have a couple of minutes, go check out the article—but it really starts off with common law states versus community property states. Most people and most of our states in the US are common law states, meaning if you own something, you own it. In community property states, we really treat things a bit differently; between spouses, it’s kind of 50/50 and we just split it up that way. Remember, though, when I used to teach this in the CFP curriculum, I always tried to go back to this point: ownership is different than divorce. A lot of people kind of get stuck in their head, like, “Oh, when you get divorced we split things up 50/50 or something equitable,” but that does not mean that is ownership. Ownership is different than divorce proceedings. Common law and community property laws in different states really set who owns the property as spouses. Really, when we’re thinking community property, there’s only a handful of states, and it’s really 50/50 between spouses, whereas in common law, you own what you buy; what’s separate is yours.

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SL: And why is the issue of basis so important?

JH: So, community property and common law property states treat basis differently depending on which state it’s in. In the exact same scenario where a husband and wife own a property—I’ll just say a farm—and they bought it for $1 million, and it’s gone to $2 million. In a common law state, they both own it 50/50. One dies; half of that, so $1 million, would go into the estate and then transfer over to the surviving spouse. The only step-up in basis—which is our cost where we don’t pay taxes above—would be that one spouse’s half interest. Presumably, if they bought it for $1 million, half of that would be gain. So, you’d get this $500,000 step-up in basis. The whole property in that case would still be $2 million, now with $1.5 million of basis. So, if the surviving spouse sold it in common law, they would have a $500,000 taxable event.

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Now, let’s shift quickly to community property. In that situation, when the first spouse dies, you would actually get a step-up in basis to the full amount of $2 million, meaning that spouse could then sell it after that time period and not pay any taxes on the gain. Hopefully, that scenario highlights the importance of using community property and these trusts because, with these large gains that we’re seeing out there across the board—equities, property, real estate—that have really gone up over the last 10 to 15 years, this is a powerful planning vehicle to reduce some of these taxes, especially for that surviving spouse. It’s less impactful when you think about going to the kids and grandkids. This is really for when the surviving spouse might need some of these assets.

SL: All right. Well, now say a client is interested in doing something like this. What are some of the requirements that states impose for doing an opt-in trust?

JH: Yeah. So, right now we have five states really that have created these community property opt-in trusts. We’ve got Alaska, Florida, Kentucky, South Dakota, and Tennessee. One of the challenges about this is you’ve got five states all with different rules around it. Regarding some of the requirements, first remember that the rules differ from state to state. The first one is an express declaration in the trust document that the property being funded in there is treated as community property. We can’t just hope that it happens; we’ve got to expressly say it.

The second part is both spouses have to execute this document and opt in. One spouse cannot create an opt-in trust for both of them for community property. So, we need both spouses. Generally speaking—I think Florida is the most lax, but for the other four—we really do need a corporate trustee or in-state trustee to manage this trust. That can be a bit of a challenge because often you’re doing this and opting in because you don’t live in that state. So, it’s not something where you’re just going to do it yourself. You’re often going to have to hire somebody here to step into this role. That is what corporate trustees do. There are ones that are set up in Alaska and all these places that specifically drive this type of business. So, that is one thing you’re going to have to watch out for. There are some other language requirements, but I’d say those are really the big ones on the requirements if you’re going to look at a community property opt-in trust.

SL: Are there any particular types of assets that can be contributed to these types of trusts?

JH: Yeah. Most of your assets really could go in here that are going to have step-up in basis capabilities. You’re thinking investment real estate, your home, LLC interests, partnership interests, and marketable securities. Those are all the ones that we’re generally going to be looking at. Really, this doesn’t help with things like IRAs, 401ks, and qualified accounts. So, there is not a lot of benefit there in those situations. Things like life insurance are going to be tax-free. So, some assets will work well. Others are not going to get this basis arbitrage planning scenario. That doesn’t mean it’s not right to still have the trust be part of that planning, but you’re not looking at it as getting this basis step-up tactic.

SL: Are there any downsides or risks that you should warn clients about if they’re interested in doing this kind of trust?

JH: Yeah. I mean, one of them is the cost. Is it really needed? Sometimes you’ll look at this and you’ll say, “Hey, there is a big opportunity here.” There are other ways to manage taxes, and especially with real estate, is it better to do this or should you be looking at a 1031 exchange and maybe selling it and buying something else? Like-kind property could be another way to defer taxes and continue this movement. So, I don’t think it’s right in every situation. It can be valuable.

If we get to too high of a net worth, though, it actually becomes unvaluable again because this does have to pass into the estate. So, if we’re trying to come up with techniques to remove things from the estate and not have them includable in the taxable estate, that’s a downside, too. You kind of have a grouping of individuals, probably in that $5 million to $10 or $12 million net worth range with appreciated assets, where this could really be valuable with some need for the surviving spouse to have this tax-free step-up.

So, it is fairly scenario-based. This is not one of those strategies that I usually would say everybody should be looking at. But for some of your clients, this could be a really great way to save them hundreds of thousands of dollars in taxes. It’s very legal. It was done on purpose. This isn’t a loophole or anything; it was created for this exact situation.

SL: Right. All right. Well, thank you, Jamie. Once again, you explained a pretty complicated topic in plain English. I was able to follow everything you said, so I really appreciate that.

JH: Well, thank you. And yeah, I didn’t mess up the math in our example either today, so it’s always a win.