When a husband and wife who reside in California make a revocable trust where they are both grantors and trustees, and they put jointly-owned property into the trust (home deeded to the trust, brokerage accounts in the name of the trust), is the trust property considered community property for federal and state income purposes? Specifically, when the first spouse dies, does the surviving spouse receive the stepped-up basis on the entire property ("double-stepped-up basis")?
Your trust document itself may provide the answer. In our trust documents, we usually include a statement that separate property transferred into the trust retains its separate character; likewise with community property. We also include three Schedules of Assets at the back of the trust to make your intentions clear to the IRS: (1) a schedule of community property assets, (2) a schedule of husband's separate property assets, and (3) a schedule of wife's separate property assets.
Absent an express statement, such as a deed wherein you took title "as husband and wife as community property" or a community-property agreement that lists all the assets that you want to receive the double-step up for capital gains tax reduction/avoidance, the IRS will impose a facts and circumstances test to determine the nature of a decedent's property interest. Factors that weigh against community property: title on the deed said something other than "community property," the funds used to acquire and maintain the property were separate, and only one spouse's name on the title or account.
Best practice is to establish a community and separate property agreement, signed and notarized by both spouses, that specifically lists every asset that is to receive the benefits of community-property capital-gains treatment. This agreement should be kept up to date as assets and account numbers change.
As an alternative, some couples create a community-property revocable living trust to hold every single community asset and one or two (as needed) separate-property revocable living trusts to hold his and hers separate property.
Take note that if you do choose to expressly characterize your property through a written agreement or the three-trust arrangement (which is perfectly legal and enforceable against IRS claims based on facts and circumstances), that agreement is also effective in the case of a divorce between the couple.
One last note, because you mentioned the step-up, I assumed that your primary concern was about capital-gains tax. Income tax, which you mention in the title of your question, is dictated by a completely different set of laws, but the determination of who owes income tax on income produced by a given property follows the same facts and circumstances test, and is subject to the same strategies I discussed.
Certified Specialist in Estate Planning, Trust and Probate Law (by the California State Bar Board of Legal Specialization)
Practicing in Westlake Village, California and Boulder, Colorado
(available for remote services throughout the states of California and Colorado in our areas of expertise including Special Needs Trusts and Planning, and issues like yours that cross-over the boundaries of Estate & Tax Law and Family Law).
In the eyes of the taxing authorities, assets held in a trust are still taxes as if held by the individual. So, if community property is held in a trust, it is still taxed as community property and receives the step up in basis when one the the settlors of the trust dies.
The term "double stepped up basis" is a slight misnomer, but the surviving spouse does receive a step up in tax basis on the entire property, subject to any limitations due to how the property was originally purchased.
I would strongly suggest that you meet with an estate planning attorney to assure you receive the most beneficial tax treatment for your assets.
Disclaimer: Please note that this answer does not constitute legal advice, and should not be relied on, since each state has different laws, each situation is fact specific, and it is impossible to evaluate a legal problem without a comprehensive consultation and review of all the facts and documents at issue. This answer does not create an attorney-client relationship.
If the decedent died in 2010, there are special rules controlling the issue of stepped up basis, and depends upon whether or not the surviving spouse received the property as versus someone else inheriting it. Also in 2010, there is a limit on the amount of step up which can occur. For assets passing to the surviving spouse, the amount of the step up can be as much as $3,000,000 plus there is a general step up available of an additional $1,300,000 for additional assets whether those pass to the suriving spouse or any one else.
With that having been said, the IRS issued a Revenue Ruling 20 to 30 years ago where the facts were that a husband and wife living in a community property state owned property as joint tenants and transferred that property into a trust. Later one spouse died, and the IRS held that because of some language in the trust (which very commonly appears in trust documents) that only one half of the assets (the decedent's half) got the stepped up basis.
Since then some California court cases have come down which might provide an arguement to the contrary, but to date there have been no court cases or IRS pronouncements contrary to the position taken in the above referenced Revenue Ruling.
Now the good news. I have never heard this issue being raised by an IRS agent on audit. This could be deliberate, oversight or just beyond the pay grade of the typical audit agent. So the survivng spouse may want to seek legal counsel familiar with all of these rules and issues, and determine how they should file their income tax returns.
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