Community Property & Estate Planning
What is Community Property?
Community property is any property owned by a married couple, or two people in a committed intimate relationship (we will refer to these as ‘spouses’ for purposes of this article), where each spouse has a “present, undivided, one-half interest in the property.” This means that each spouse has equal access to the whole property, but only owns one-half of the property. Thus, each spouse can control the property just like the owner of separate property would, subject to some limitations. For example, a spouse must give permission for the other spouse to (1) devise or bequeath by will more than one-half of the property, (2) give away, sell, convey, or use community property as collateral, or (3) purchase real property with community funds.
Money or property earned during the marriage or partnership is presumed to be community property. This does not include gifts or inheritances to one spouse before or during marriage, or any rents, issues, and profits derived from separate property.
What is a Community Property Agreement?
A Community Property Agreement is a contract between spouses that allows the couple to classify property as separate or community property. Such an agreement can apply to currently-owned property and property that will be acquired in the future. Further, the agreement can provide for property to be classified one way during life and another way upon the death of one spouse. A Community Property Agreement is executed with a written instrument and must be recorded in the same manner as a deed to real estate.
How is a Community Property Agreement used in estate planning?
A Community Property Agreement can be flexible in helping to achieve different goals for estate planning.
- Protect assets from creditors of one spouse. By classifying assets as the separate property of one spouse, you can insulate those assets from the creditors of the other spouse. However, if the agreement is made to defraud creditors, a judge can set aside or cancel the contract. As such, it is critical to consult an attorney when considering this type of move.
- Avoid probate. Because a Community Property Agreement can change the status of property upon death, a couple can provide that all property, whether separate or community, is to be classified as the separate property of the surviving spouse, thereby avoiding probate (and ancillary probate). Note that the agreement must refer to ALL property in order to avoid probate, which can create complications in tax planning (see below).
- Create ownership rights. Owners of community property have different rights from owners of separate property, including the ability to sell or restrict the property, as in obtaining a mortgage secured against the property. Couples can convert community property into separate property if they want one spouse to have unilateral control over the property. Conversely, the couple can also convert separate property into community property so that both must take part in the decisions about how to use the property.
- Clarify ownership. When community and separate assets are commingled, meaning mixed together, separate property can end up being converted to community property. Consider a situation where community funds are used to pay for the cost of the separate property, such as the monthly payments or property taxes. For example, if one spouse bought a house before marriage, that house is classified as separate property; but if both spouses contribute to paying the mortgage or taxes after marriage from their earnings, then that house could end up being characterized as community property, because both spouses have combined, or commingled, their own assets to maintain that house. Room for doubt as to the status of such property can lead to costly court battles, but a Community Property Agreement can preempt all disputes as to status and thereby avoid costly litigation between family members.
Although they might suit some couples, Community Property Agreements also have inherent limitations that can lead to unforeseen consequences in certain circumstances which limit its applicability.
Not all states are community property states. Because Community Property Agreements can only control the status of property owned by a married couple in a community property state like Washington, this agreement (i) does not avoid probate for the surviving spouse, or for property not in a community property state, (ii) does not provide for gifts to children and (iii) could be disregarded if the couple moves to a non-community property state.
Also, because the agreement is a legally binding contract, the agreement (iv) survives a divorce and, if converting separate to community property, (v) limits your ability to control and manage the property if the other spouse or partner becomes incompetent or refuses to cooperate.
A Community Property Agreement (vi) could be set aside or canceled by the superior court for fraud or other equitable grounds, such as an attempt to evade creditors. RCW 26.16.120. Finally, because the community asset does not pass through probate, (vii) you lose the advantages associated with probate, such as tax benefits and creditor non-claim statutes.
Other potential drawbacks depend on the surrounding circumstances:
- Family LLC complications. Let’s consider an interest in a Family LLC held by the husband as separate property. In some instances, Family LLC bylaws may require that only blood relatives own a share in the company. However, converting the husband’s separate interest into community property will give his wife, a non-blood relative, a share of the company. This can result in a loss of ownership or trigger some unfavorable action by the LLC, depending on the bylaws.
- Unintended disinheritance. Community Property Agreements override the provisions of a will or trust that was one before the Agreement. This can have devastating results if not understood, such as an unintentional disinheritance. For example, if a husband’s will provides that an asset will be gifted to his brother, but a later-dated Community Property Agreement provides that the asset will transfer to the wife as her own separate property under a Community Property Agreement, the agreement will preempt the gift – resulting in the asset transferring to the wife rather than the brother.
- Tax Consequences: As mentioned above, a Community Property Agreement will preempt your will if it was signed prior to that will. Therefore, any careful and detailed tax planning you have done in your will is lost at the time of your death, because the Agreement means that everything simply goes to your spouse. Even if you’ve set up various trusts, such as marital deduction trusts, to avoid estate taxes, it simply won’t be effective if you have not revoked your Community Property Agreement.
A Community Property Agreement can be a valuable estate planning tool. However, due to the potential and actual drawbacks, this option is not ideal for all estates. Make sure you consult an experienced Estate Planning attorney to discuss and understand the consequences of a Community Property Agreement in your situation.