Hidden Dangers of California's Community Property Law
Community property has traditionally been a state law ownership concept applied to married couples. In general, property acquired and income earned by either spouse during a marriage is equally owned by the "community" as a partnership.
Note: Assets brought into a marriage, gifts from a third party or an inheritance are generally not community property.
Community property for married couples is both a property ownership and tax concept. Each spouse is entitled to 50% of the community; thus, if the couple files a separate tax return, each reports his or her share of community property. Also, upon the death of one spouse, only 50% of community property belonging to the deceased spouse is subject to estate taxes.
Community Property Advantages
The main advantage of community property is that both spouses or partners share equally in the income and assets acquired during the marriage, regardless of which spouse or partner actually generated the income or acquired the assets. Traditionally, this protected the stay-at-home spouse who earned little or no income, by treating that person as an equal in the relationship.
California's Domestic Partner Act
California's Domestic Partner Rights and Responsibilities Act of 2003 (Act) became effective on January 2, 2005 for registered domestic partners (see the November, 2004 newsletter). Under the Act, community property concepts apply to property rights, but not for tax purposes. Each partner of a domestic partnership is entitled to 50% of the community property upon death or dissolution. However, if one partner dies, community property concepts are not used to determine the size of the decedent's estate.
California's Community Property Trap
Unlike other states in which community property is actually owned 50/50 by each spouse or partner, under California's community property law, each spouse or partner has an interest in the entire community property. A debt or tax liability of one spouse or partner may be paid from the debtor-spouse's or partner's separate property and out of the entire community property, but not from the non-debtor spouse's or partner's separate property.
This distinction is important because in California, the entire community property is subject to the claims of creditors of one spouse or partner, even debts that were incurred prior to marriage or registration!
For example, if husband incurred tax debts of $10,000 prior to marriage, IRS could satisfy the debt from the entire community property, including wife's share.
Asset Protection Planning
In contrast, real property owned as joint tenants, rather than as community property, may be preferable from a creditor-protection standpoint. Note: Owning a joint bank account will not offer creditor protection since the debtor-spouse or partner may withdraw the entire amount.
Better still, owning property as tenants in common (each spouse or partner owns 50% as his or her separate property) will protect the innocent spouse or partner from future claims of creditors, including IRS. In many cases, this will require a signed agreement meeting California's stringent statutory requirements. In fact, any couple contemplating a marriage or registration where one party has pre-existing debts should have a signed agreement to protect the non-debtor party.
A major advantage of community property for married couples occurs when one spouse dies. The entire community property asset is revalued to fair market value, not just the decedent's 50% interest, thereby eliminating any tax on the asset's appreciation to the date of death. In contrast, only the decedent's 50% share is revalued if the property was held as joint tenants or as tenants in common. Note: This 50% rule only applies to married couples holding property in joint tenancy.
However, since the Act does not apply for tax purposes, community property provides no tax advantages for domestic partners, although this is an evolving area of law.
Under the Act, the trade-off for domestic registered partners is whether the protection offered by community property to the lower income partner is outweighed by the disadvantage of exposing the entire community property to the debts of one of the partners.
For married couples, in addition to the trade-off between asset protection versus equal ownership, there is the added tax advantage that occurs when one spouse dies and the entire community property assets are revalued to fair market value, thereby eliminating potential taxable gains in appreciated assets.