Article on Community Property
Numerous provisions of the Internal Revenue Code (“IRC” or the “Code”) treat community property substantially different than marital or separate property. Generally, the determination of whether property is community or non-community property (sometimes referred to as common law property) is a matter of state law.
Before 1948, there was just one tax rate schedule with numerous rates for different levels of income and everyone had to file his or her own tax return. Married couples in community property states were treated dramatically different than married couples in non-community property states. Married couples in community property states were deemed to each have earned one-half of the community income. Filing and reporting only half of the income on two separate returns had the result of taxing the total income at lower overall tax rates. A married couple with only one earner in a common law property state was taxed at far higher marginal rates than their counterparts in community property states.
Several states tried to rectify the disparate tax treatment by creating a form of community property. The laws ranged from elective community property to actual vested interests in the property for both spouses. These measures were met with an onslaught of legislation with varying degrees of success.
The Revenue Act of 1948 provided for a filing status called “married filing jointly” (herein, “jointly” or “joint filing”). Joint filing had the effect of dividing the income and computing the tax on one-half of the income, then multiplying the result by two to get the total. Generally, this resulted in the income being taxed at lower rates. This put married couples in community property and non-community property states in the same relative position with respect to the calculation of income tax. Taxpayers are still treated unfairly if they choose to opt out of joint filing.
In 1962, taxpayers were again confronted with disparate treatment when the Supreme Court held that a divorce was a taxable event. Spouses in community property states were not taxed because each spouse owned one-half of all assets; their property divisions were just splitting the property. However, couples divorcing in non-community property states were essentially buying and selling property in their divorces; thus, those “transactions” were taxable. Again, the states countered with legislation designed to obtain equal treatment for their residents. A litany of legislation followed with varying results. Finally, in 1984, Congress acquiesced with legislation. IRC section 1041, which provides that there is no gain or loss on divorce, made the issue moot.
However, income tax brackets, rates, and treatment on divorce were never the only tax areas in which there was tax favored treatment for taxpayers in community property states. IRC section 1014 gives favorable tax treatment to community property upon death as well; it provides for a step-up in basis of both halves of community property in which the decedent held an interest, even if only one-half of the property is included in the decedent’s estate. This tax-treatment is not afforded to taxpayers in non-community property states. Those taxpayers get a step-up in basis of only one-half of jointly owned property.
One would think the discrepancies in basis upon death would bother state legislators as much as the income tax disparities which occurred during World War II and the disparities upon divorce in the 1960s. However, that is not the case. Presumably, the income tax cost hit wealthy men in World War II and also upon divorce. However, since women generally outlive their husbands, the tax cost of lower bases as a result of death is felt more by women, and then, only when they sell the assets. State legislators do not appear to care about these discrepancies, or perhaps, are just not aware of them.
Over the decades, the state legislatures have tried to create a version of community property that would provide the beneficial tax treatment of community property for their constituents, without completely revising their whole property system. This Article explores the implications and possibilities of individuals of non-community property states’ ability to define their property rights so as to create a “community of property” for the purpose of obtaining a step-up in basis of both halves of property upon death. One would hope that state legislators would be as passionate about these tax disparities as they were about the income tax disparities during World War II and in the 1960s. However, in the absence of action on the part of state legislators, are there any alternatives for taxpayers?
There is no rationale for providing this favored tax treatment to the surviving spouse in a community property state, yet denying it to the surviving spouse in a non-community property state. In lieu of action by a state to bring about equal treatment, it may be possible for the parties themselves to create community property.
In most non-community property states the courts allow spouses to enter into prenuptial and postnuptial property agreements. Further, if the state has passed the Uniform Probate Code, the parties may choose which state’s laws they would like to have the court apply when interpreting their agreement upon their death. Thus, spouses should be able to create property agreements based on community property laws, and the law should provide favorable tax treatment for those agreements. It would be tragic to discover that we have had this power all along and simply did not know it.