In 2010, Tennessee became the second state to allow “community property trusts” and put our state far ahead of most other states in its estate planning laws. The law applies to both resident and nonresident married couples, allowing them to convert their property to community property by transferring the property to this very specific type of trust, known as a “Tennessee Community Property Trust,” which is generally a type of revocable living trust.
1. Community Property Defined. Community property is a property ownership system that has existed a very long time in a few other states – to provide for equal ownership of property by a husband and wife, including sharing in the appreciation and income from the property. By default, Tennessee is a “separate property” state – where each spouse is independent for property ownership. The choice to have community property instead can be accomplished by establishing one of these trusts, even a common law state such as Tennessee.
2. Income Tax Benefits. At the death of the first spouse to die, both spouses’ interests in the community property will be eligible to receive a basis increase (not to exceed fair market value). As a result, no capital gains tax will be due if the first spouse dies and the surviving spouse decides to sell any of the assets in the community property trust. Further, the increased basis will allow for increased depreciation deductions for business and investment depreciable assets. By contrast, if the same property had been jointly-owned by the husband and wife in Tennessee, only one-half of the property would receive such a “stepped-up” adjustment in basis. The income tax benefit can be substantial for many couples.
3. Creating a Qualifying Trust. Although the evaluation of whether such a trust is beneficial is complex, the requirements to create a Tennessee Community Property Trust is very straightforward. The trust must (1) state that it is a Tennessee Community Property Trust; (2) contain certain language that gives notice of the consequences of the trust; (3) appoint at least one trustee who is Tennessee resident or a Tennessee bank or trust company; and (4) be signed by both spouses.
4. Not for Asset Protection. A debt incurred by only one spouse before or during marriage may be satisfied from that spouse’s one-half share of a community property trust and a debt incurred by both spouses during marriage may be satisfied from all of the trust assets. For this reason, a Tennessee Community Property Trust has inferior creditor protection to tenancy by the entirety ownership, and should not be utilized by couples who anticipate creditor problems.
5. Not for Unstable Marriages. If the spouses divorce, the trust will terminate and the trustee must distribute one-half of the trust assets to each spouse. When property is distributed from a community property trust, it will no longer constitute community property (eliminating the tax benefits). The equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust.
6. Not for Capital Loss Property. Note that the community property income tax rules do “cut both ways” so if you have property with an existing built-in capital loss, it is advantageous for that asset to be left out of the community property system.
7. Not for Immediate Tax Reduction. Unless one spouse is known to be terminally ill, this type of trust planning is not used to artificially avoid capital gains. The tax benefit only occurs upon the death of a spouse. The trust does not alter the tax consequences if the assets are sold while both community property spouses are living.
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