Many married couples approach shared finances with a “what’s mine is yours” mindset. The law, however, takes a more structured view. From a legal and tax perspective, determining ownership between spouses carries significant consequences – and those consequences vary by state.
The rules governing how assets are owned, transferred, and taxed at death differ substantially depending on whether the couple lives in a community property state or a common law state. The nine community property states follow a fundamentally different framework – one that presents both planning opportunities and potential pitfalls.
For families who live in, or may move to, a community property state, thoughtful planning is essential. Property distinctions can directly impact taxes, asset protection, and how efficiently wealth passes to the next generation.
What is community property?
Community property is a form of ownership between spouses in which each spouse owns an undivided one-half interest in the asset. In community property states, assets acquired during marriage through earnings, along with the rents, profits, and income generated by such earnings, are generally characterized as community property. In Texas – although many people only realize this if issues arise – income from separate property is also community property.
Separate property, by contrast, includes assets owned before marriage or received individually during marriage as a gift or inheritance.
In Texas, the inception of title rule applies: An asset’s character – whether separate or community – is determined at the moment a right to it is acquired. A home purchased or business started before marriage remains separate property – even if paid down during marriage – while the same purchase during marriage is presumed community property. You can imagine the tension this can cause in the event of divorce, and it can also create conflict in an estate administration.
Importantly, community property treatment applies regardless of title. In common law states, ownership generally follows title – meaning each spouse owns what is in their name.
In common law states, married couples often own assets jointly, but absent a specific arrangement, each spouse's paycheck belongs to that spouse alone.1
These structural differences have meaningful implications across estate planning, taxation, and asset protection.
The step-up in basis advantage
At death, assets included in a taxable estate generally receive a step-up in income tax basis to fair market value. For example, stock purchased for $10,000 and worth $100,000 at death receives a new basis of $100,000, eliminating built-in gain if sold immediately. For families with large, unrealized gains in their investment portfolios, these rules represent one of the most significant wealth transfer levers available. Community property states hold a decisive advantage.
- Common law state
- Community property state
When a married person dies, only that spouse’s separately owned assets and share of jointly owned assets receive a step-up. For example, for a married couple in a common law state who holds a brokerage account in both names as joint tenants, only one-half of the account receives a step-up at the first spouse's death. The surviving spouse's half retains its original cost basis.
Because both spouses are deemed to own an undivided one-half interest in the entirety of the account, the whole asset (i.e., both halves of the account) is treated as passing under the decedent's estate for purposes of the step-up rules under IRC Section 1014(b)(6). This results in the surviving spouse receiving a step-up on 100% of the account's value, even though only the decedent’s half was included in the decedent’s taxable estate for federal transfer tax purposes. This applies regardless of title, provided it is owned as community property.
Suppose the following:
- A husband and wife live in Texas.
- The wife purchases a vacation residence using income from her job and titles the asset in her sole name, though the residence is held as community property with husband due to the funds being derived from post-marriage income.
- The income tax basis in the residence is $500,000.
- The husband passes away when the fair market value of the residence is $3 million.
Under community property rules, the entire asset receives a step-up to the $3 million date-of-death value. If the wife sells the residence immediately, she would not owe capital gains tax.
In a common law state, the wife would retain her $500,000 original cost basis, leaving $2.5 million of embedded gain potentially subject to capital gains tax.
Separate property in community property states only receives a step-up at the owner spouse’s death. In some cases, couples may explore converting separate property to community property through a marital property transmutation agreement to capture a full step-up at either spouse’s death.2 However, this shifts ownership and control and requires careful analysis.
Creditor protection considerations
Community property ownership also affects creditor exposure, and families should understand the risks and considerations.
Each state has nuances in the law when it comes to marital property and creditor protection. In Texas, liability can depend on whether the property is considered community property subject to joint management and control or sole management community property.
Joint management community property, such as joint accounts, may be exposed to liabilities incurred by either spouse, even if only one spouse is responsible. This means that if one spouse runs a business that incurs significant liability, the family’s joint community property assets could be exposed to that liability, even if the other spouse was not involved in the business whatsoever. This risk is not as significant in a common law jurisdiction where creditor exposure more closely follows title.
Separate property and sole management community property are generally better protected, creating important planning considerations when one spouse faces greater liability risk than the other. It is essential to understand which assets are community and which are separate and to maintain clear records supporting that characterization.
Estate planning pitfalls
In community property states, properly funding trusts is essential to preserve the integrity of your estate plan.
Consider irrevocable life insurance trusts (ILITs), which remain an important estate planning vehicle to hold life insurance outside of the taxable estate while ensuring that death benefit proceeds are available to provide liquidity for beneficiaries.
When a married couple funds an ILIT with premiums paid from community property (which is often the default when premiums are paid from earnings generated during the marriage), both spouses are treated as transferors of their respective one-half community property interest in the cash contribution, regardless of who is named as a grantor of the trust or whose bank account the funds come from. Accordingly, while using community property to fund an ILIT for the sole benefit of the couple’s descendants is fine, issues arise if a spouse is included as a beneficiary. Specifically, if community property is used to pay premiums, both spouses are deemed to have made gifts, which can cause the ILIT assets to be included in the beneficiary spouse’s taxable estate, defeating the primary purpose of the ILIT.
Similar issues arise in any scenario where a grantor’s spouse is named as a beneficiary of an intervivos irrevocable trust, such as a spousal lifetime access trust (SLAT). A community property gift to the SLAT could cause estate inclusion for the beneficiary spouse.
To avoid this, trusts benefiting a spouse should generally be funded with the grantor’s separate property. If the grantor spouse does not have separate property available to fund the trust, the couple could potentially create separate property for the grantor spouse through a partition agreement, which is a form of transmutation agreement that divides existing community property into separate property.
Marital property agreements
Marital property agreements allow spouses to change the character of property between spouses, including through transmutation and partition agreements. These can be useful in several planning contexts, including ILIT funding, capturing the step-up, liability management, and simplifying estate administration.
Transmutation agreements can be powerful planning tools, but they are subject to state law formalities and meaningful limitations. In Texas, for example, a transmutation agreement generally must be in writing and signed by the spouse whose property rights are affected; oral agreements or mere commingling typically are not enough. Because these agreements can affect creditor rights, transfer tax planning, and income tax outcomes, they should be implemented carefully and documented clearly to reduce the risk of disputes with spouses, estates, creditors, or taxing authorities.
Several important limitations should be considered with counsel, including:
- Transmutation agreements cannot be used to defraud creditors. A conversion that takes place after a liability has arisen, or in anticipation of a known claim, may be unwound by a court.
- Converting property characterization between community and separate can have implications on leveraging your respective transfer tax exemptions.
- When the transmutation and gift occur in quick succession, the IRS may scrutinize the sequence as a step transaction and collapse it into a single taxable event, which would likely undermine the tax objectives.
Moving between states
Relocating between community property and common law states adds complexity.
Community property acquired in a prior state often retains its character but may be treated differently under new state law (i.e., how the property is handled in a divorce or upon a spouse’s death, its management, etc.).
From a tax perspective, assets that were community property and would have qualified for a full step-up in basis under IRC Section 1014(b)(6) may lose that treatment if the community property character is not properly preserved. Reviewing your estate plan upon any interstate move – particularly between community property and common law states – is essential. For example, if you move from Texas to New York, the documents that governed your affairs in Texas, such as your will, revocable trust, and powers of attorney, may need to be updated to reflect the laws of New York, and you may want to take action to affirmatively preserve your community property (assuming doing so aligns with your goals).
Assets acquired in a common law state typically retain their character (e.g., remain separate property of the spouse who owned them, remain held in joint tenancy or tenancy in common as originally titled, etc.) and do not automatically convert to community property. However, future earnings and acquisitions will be treated as community property.
Some community property states recognize “quasi-community property,” which refers to assets acquired elsewhere that would be community property under local laws. While some states apply this classification upon death and divorce, others, like Texas, apply it exclusively during divorce proceedings.
The path for couples moving between states is not one-size-fits-all. If you move from New York to Texas and you were happy with the system in New York, you and your spouse may formally opt out of the Texas community property regime to avoid potential conflicts arising from mixing New York marital property with Texas community property. Conversely, you may consider everything as joint property and value the community property step-up rules and choose to convert your joint property to community property.
Several common law states have adopted tools designed to bridge the gap between the marital property rules.
- Some states have enacted versions of the Uniform Disposition of Community Property Rights at Death Act, which provides a framework for recognizing and honoring the community property character of assets that couples bring with them from community property jurisdictions when one spouse dies.
- Other states permit couples to hold assets in a community property trust that can preserve or even establish community property treatment for assets held within it, regardless of the couple’s domicile.
The availability and specifics of these tools vary by state.
For any couple crossing state lines, we recommend addressing the following with your advisory team:
- Review and update your will and revocable trust to reflect the laws of your new state.
- Confirm how your existing assets will be characterized in the new state, and consider whether any marital property agreement is warranted.
- Review beneficiary designations on retirement accounts and life insurance policies, as these may need to be updated.
- Assess whether assets brought from a community property state should be affirmatively characterized in the new estate planning documents to preserve their community property character.
- Evaluate whether a community property trust or similar structure is available and appropriate given your assets and goals.
- Engage both your estate planning attorney and your tax advisor, as both the estate tax and income tax implications of the move deserve attention.
Conclusion
Given the technical requirements and potential for unintended consequences, any estate planning affecting marital property should always be implemented with the help of experienced legal counsel familiar with both the marital property laws of the relevant state(s) and the applicable federal gift and estate tax rules.
Please reach out to your BBH relationship team to learn more.
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1 Of course, exceptions apply, and any of the above characterizations of marital property may be altered by either a premarital or post-marital agreement.
2 The transmutation must be completed more than one year from a decedent spouse’s death or it will be subject to Section 1014(e) of the Internal Revenue Code and risk not receiving a double step-up.
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