OCTOBER 9, 2000 VOLUME 8, NUMBER 15

Arizona is one of nine “community property” states in the country, and that can be the source of some confusion about estate planning, taxes and property ownership rights for married couples. Recent changes in Arizona’s law make the “community property” designation a little more friendly and understandable, and the benefits to this unique property ownership choice are now clearer.

“Community property” concepts were not part of the English common law. Under the system imported to most of the American states, property was owned by one spouse or the other, though the non-owner might acquire some rights in his or her spouse’s property. The French and Spanish, however, understood the marital community to be a separate entity from either spouse individually, and permitted the “community” to own property. Each spouse then holds an equal interest in the community’s property.

Those American states with rich Spanish or French histories tended to adopt some version of the community property concept. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are community property states, although the method of implementing the concept varies somewhat. Alaska also permits some trust assets to be held as community property.

In community property states a married couple is presumed to hold assets as community property regardless of the actual title on the asset. Couples may, however, choose to hold their property in joint tenancy or as tenants in common if they wish.

One important advantage to having assets titled as community property comes, oddly enough, from federal tax law. Although capital gains taxes are ordinarily due any time an appreciated asset is sold, the increased value of property held by a decedent at the time of death is not taxed. The property’s income tax “basis” is said to “step up” to its value on the date of the owner’s death, often resulting in substantial income tax savings for heirs.

Jointly owned property only receives a partial “step up” in basis. Property held in joint tenancy will usually only get half the income tax benefit on the death of one joint owner. Community property, however, is treated differently: the entire value of a community property asset gets “stepped up” to the value on the first spouse’s death, resulting in twice the income tax savings.

The main drawback to holding community property in Arizona has long been the requirement of a probate proceeding to pass the property to the surviving spouse. Although the long-term tax savings can be substantial, the probate costs are immediate and, in most people’s minds, too high. Since 1995 Arizona has permitted married couples the best of both worlds: property can be held as “community property with right of survivorship” and secure the favorable income tax treatment while still avoiding the probate process. The value of this type of property ownership is, of course, restricted to married couples.

One caveat: some commentators, relying on fairly arcane interpretations of the federal tax law, argue that the “community property with right of survivorship” designation could conceivably be found to result in no step up in tax basis at all. So far the federal government has not taken such a position, but there remains some slight possibility of a problem. In addition, the effect of titling separate property as community property (with or without the “right of survivorship” language) has more than just tax effects. In other words, you should consult an Arizona attorney before changing title on your existing assets or deciding how to title a new acquisition.