For many years, Tennessee looked at spousal assets as either marital or separate. Marital property, meaning assets acquired during the course of marriage, were subject to equitable distribution if the marriage ended in divorce.
Separate property referred to items that were acquired outside of the marriage. This could include property purchased prior to marriage as well as to gifts and inheritances a spouse received during marriage. Now, spouses have a third option for property ownership: community property.
In 2010, Tennessee passed the Tennessee Community Property Trust Act of 2010. This bill allows married couples to convert property owned either jointly or separately into community property by placing the assets inside a community property trust (CPT).
The primary benefit of using a CPT is that there can be significant tax advantages for couples that own highly appreciated assets.
How community property trusts reduce capital gains taxes
Imagine a couple purchases some real estate for investment purposes for $250,000. Some time later, one spouse dies when the property is worth $750,000. The property has total gains of $500,000.
Without a CPT, only half of the property would likely receive a step-up in basis. This means the surviving spouse’s cost basis would be $375,000 (50% of the gains, plus 50% of the original cost basis). If the surviving spouse sells the property, they may face capital gains taxes on the $375,000 of gains. That could leave the surviving spouse with a tax bill of nearly $90,000 if taxed at the maximum rate.
However, if the real estate is placed in a CPT, the entire property will likely see a step-up in basis. This means that the surviving spouse’s new cost basis would be $750,000. If the property is then sold for $750,000, there will be no capital gains taxes incurred.
Potential downsides of using a community property trust
While there is good reason to consider using a CPT, there are negative consequences that could arise when using one.
One disadvantage is that the property in the CPT has less protection from creditors and lawsuits. If either spouse is sued or winds up with a large amount of debt, both parties could lose their share of the property.
The CPT can also make things more disadvantage for a spouse if the marriage ends in divorce. Separate assets are typically not included in the distribution of assets in divorce. However, if the assets are in a CPT, then each spouse may be eligible to receive 50% of the assets, regardless of how they were originally acquired.
Tax planning is a key element of a comprehensive estate plan. Taking steps to limit how much of your assets may be taxed can offer lasting benefits for your loved ones.