The Community Property Trust Act took effect in Kentucky on July 15, 2020. This new law provides married couples with the option of having some or all of their assets classified as “community property” and held in a community-property trust. For the right couple and the right assets, this is welcome legislation.
There are two property regimes in the United States: “separate property” states and “community property” states. The laws and regulations for each regime primarily affect tax matters, estate planning considerations, and family law issues, such as divorce.
Kentucky is a “separate property” state, in which each asset of married spouses is classified either as separate or marital. Separate (or non-marital) property belongs to one spouse because it was owned before marriage or received as a gift or through inheritance.
Marital property is basically everything else—any property that comes into the marriage that is not separate property. An asset is marital property if either spouse acquired it during the marriage (such as income from employment) or they obtained it jointly (such as a primary residence).
Only nine states have “community property” regimes, but South Dakota, Tennessee, Alaska, and now Kentucky allow spouses designate some or all their assets as community property.
While laws relating to community property vary somewhat from state to state, in a community-property state, an asset is either community property or separate property, defined similarly to marital or separate property in a separate-property state. However, the property is treated differently in the event of divorce and at death.
Property regime impacts taxation
The main potential advantage of the new option is the favorable valuation of property, for tax purposes, to the surviving spouse when the first spouse dies. For federal tax purposes, the fair market value (FMV) – usually set on the date of death – of an asset owned by the deceased spouse becomes its new value. This is called a stepped-up basis (or stepped down if the valuation depreciated instead of appreciated).
If spouses jointly own an asset in a separate-property state (like Kentucky), the decedent’s half receives the stepped-up value and the surviving spouse’s half stays at the original value (usually set at the time of purchase). If the surviving spouse sells the asset, he or she would have a larger increase in value for their half because the step-up in basis did not apply – resulting in a larger taxable gain.
If the same asset were classified as community property, when the first spouse dies, the entire asset (both halves) receives the stepped-up value, leaving no gain to be taxed upon sale of the asset.
The Kentucky community property trust
To create a valid community property trust under the new legislation:
- Either or both spouses must transfer assets to the trust;
- The trust must expressly state that it is a Kentucky community property trust and contain a capitalized warning that the trust may have extensive legal consequences and impact on spousal rights;
- Either or both spouses may be trustees, but at least one trustee must be a Kentucky resident, or a bank or trust company allowed to act as trustee in Kentucky; and
- Both spouses must sign the trust document.
The spouses have a wide berth to include agreed-upon terms in the trust document regarding matters vis-a-vis trust assets, including rights, obligations, management, control, disposition on death or divorce (or another agreed-upon event), and choice of state law that will apply (that of Kentucky or another state). The Act has additional rules for trust administration.
This post scratches the surface of matters this new law may touch. As community-property rights are new to Kentucky and because courts have not yet interpreted any of its provisions, married couples should consult with a lawyer to determine whether a community-property trust is right for them, their estate- and tax-planning needs, and their family. In addition, the IRS, historically, has not been in favor of elective community-property schemes and recently declined to comment, so informed legal counsel can monitor further IRS action.