How can I benefit from a community property trust?

Many married couples in Tennessee are surprised to learn that residents of community property states may receive more favorable income tax treatment when one spouse dies. Fortunately, Tennessee law allows married couples to establish a community property trust, which may provide similar tax advantages in appropriate circumstances.

The Tax Advantage of Community Property

One of the most significant tax benefits of community property is the potential for a full step-up in income tax basis when the first spouse dies.

An asset's basis is generally what it cost to acquire the asset, adjusted for certain tax events. When an asset is later sold, capital gains tax is generally calculated based on the difference between the selling price and the asset's adjusted basis.

Under federal tax law, when one spouse dies owning community property, both the deceased spouse's interest and the surviving spouse's interest in the community property generally receive a new basis equal to the property's fair market value as of the date of death. This can substantially reduce—or even eliminate—capital gains tax if the surviving spouse later sells the property.

How Tennessee Generally Differs

Tennessee is not a community property state. As a result, married couples who own property under Tennessee's traditional property laws generally do not receive the same basis adjustment for the surviving spouse's share of jointly owned property at the first spouse's death.

For many appreciated assets, this means the surviving spouse could owe significantly more capital gains tax if the asset is sold in the future than would be the case under community property rules.

Community Property Trusts

The Tennessee Community Property Trust Act allows married couples to create a joint revocable trust, known as a community property trust, that may enable qualifying trust assets to receive the same favorable basis adjustment available in community property states.

Placing assets into a community property trust does not immediately create a stepped-up basis, nor will it reduce capital gain tax liability on assets sold while both spouses are living. Instead, if the trust satisfies applicable legal requirements, both spouses' interests in qualifying trust assets may receive a basis adjustment to fair market value upon the death of the first spouse. This can significantly reduce future capital gains taxes for the surviving spouse.

Because these rules are governed by both Tennessee law and federal tax law, careful drafting and implementation are essential.

An Effective Estate Planning Strategy

For married couples who own highly appreciated assets—such as real estate, family businesses, or investment portfolios—a community property trust can be an effective estate planning tool. By potentially reducing future capital gains taxes, the trust may preserve more of your family's wealth and provide greater financial flexibility for the surviving spouse.

Every family's circumstances are different. An experienced estate planning attorney can help determine whether a community property trust is appropriate as part of your overall estate plan.