An important step of preparing an estate plan is to consider how your assets will be affected by taxation. Your beneficiaries will not inherit the value you intended if their inheritance is minimized by the check cut to the IRS. When a person's assets include investments and properties that have significantly appreciated over time, you are at risk of paying Uncle Sam a pretty penny.
Can these capital gains taxes be limited or avoided completely? For married couples, the short answer is yes. These taxes can be avoided with a Tennessee Community Property Trust.
How Capital Gains Tax Works
Before we get into the mechanics of the Tennessee Community Property Trusts let's briefly review how the capital gains tax works.
The capital gains tax is a tax on the realized appreciation of assets. Put simply, what this means is that if you sell a stock, real estate, a painting, a valuable coin, or any other appreciable asset for a gain, you will likely pay taxes on that profit. Let's take a look at the following scenarios:
Husband and Wife purchase a property for $100,000. The purchase price is known as their tax basis – what they paid for the property. Over the years, that property has increased substantially in value such that the property is now worth $200,000. If the property is then sold, the couple will pay a minimum of 15% capital gains tax on the sale proceeds, in this case $15,000.
Using this same example, what if the Husband and Wife both die and their children want to immediately sell the property? Would they have to pay capital gains tax?
The short answer is no. The IRS allows for a complete step up in tax basis when the owner of a property dies. As such, the children's basis would not be their parent's basis of $100,000. Rather it would be the market value of the property at the last to die of Husband and Wife, or in this example, $200,000. Accordingly, if the children then sold the property for $200,000 (the value of the property at the death of both their mother and father), they would pay no capital gains tax
But what if the Husband died and the Wife wanted to sell the property? Would she be able to sell the property without capital gains tax?
No. In this scenario, the Wife would receive only a half step up in basis. To calculate this new basis, you take the original basis of the property ($100,000) and add it to the fair market value of the property at the Husband's death ($200,000) and divide by 2. So in this example, the Wife's new tax basis would be $150,000. ($100,000 + $200,000 = $300,000 ÷ 2 = $150,000). If Wife then sold the property, she would pay capital gains tax on the difference between her new basis, $150,000 and the fair market value of the property, $200,000. In this case, the Wife would pay a minimum of 15% tax on $50,000, or $7,500.
That is still a significant chunk of change. Is there a way to avoid that capital gains tax after the first spouse's death? Yes, the solution is the Tennessee Community Property Trust.
What is a Community Property Trust?
Here is how it works: Let's say the couple's basis in the property is $100,000. Husband then dies. If the property is titled in a Tennessee Community Property Trust, the Wife would get a complete step up in basis to the market value of the property at Husband's death. As such, if she then sold the property shortly after Husband's death at market value, she would pay no capital gains tax whatsoever.
To give another example, if you purchased 100 shares of Amazon stock in 1999 for $50 per share (a $5,000 initial investment) that stock is now worth $260,000.00. You have capital gains of $255,000. If you sold the stock today you would pay a little less than $40,000 in taxes.
However, if you held that stock in a Community Property Trust, your spouse would receive a complete step up in basis to the market value of the stock at your death. If your spouse then sells the stock, he/she would pay nothing in capital gains tax.
The following diagram shows how a CPT can save you literally thousands of dollars by avoiding capital gains tax through a step up in basis. Each of the following scenarios begins with a Husband and Wife who have jointly purchased a property for $100,000. The flow chart shows the taxable amount based on the presence or absence of a community property trust as well as the time of sale.
Do I need a Community Property Trust?
CPTs are most often used with real estate investments and securities. These types of trust can also be especially useful if one spouse is the primary person managing the asset.
As an example, if a Husband and Wife have many rental properties and the Husband is the primary person managing those properties, the Wife may not want the burden of caring for the property at Husband's death. She may just want to sell the properties and live off of those funds. In that case, a Community Property Trust would be a perfect fit.
Similarly, let's say Wife has a professional practice and she runs her business out of an office Husband and Wife own together. Husband is not involved in the business and would not take it over after Wife's death. In that case, placing the property in a Community Property would work well because the property would get a complete step up in basis at the Wife's death, allowing Husband to sell the property with little to no capital gains.
A quick word on personal residences: Your personal home has a built-in capital gains tax exemption. For married couples, the exemption is currently set at $500,000. So if you have a capital gains under $500,000 when you sell your personal residence, you pay no capital gains. However, that only applies to your personal residence, not investment properties or second homes.
How do I create a Tennessee Community Property Trust?
The process of creating a Community Property Trust is similar to creating a basic revocable trust. When a CPT is created, properties in the creator's personal name are re-titled into the name of the trust. The creators of the trust, otherwise known as the grantors or settlors, are the co-trustees during their lifetime. As co-trustees, they control any property in the CPT and use such property for their own benefit, just like if they personally owned it.
Can you create a Community Property Trust as a single person?
No. CPTs are designed specifically for married couples. If you are a single person, you could not create a CPT.
The reason why the CPT was created by the Tennessee General Assembly was to allow Tennessee couples (or other out of state couples) to achieve the same tax benefits that couples in community property states have with the IRS. In short, those couples residing in community property states such as Florida, Texas, and California receive this significant tax advantage at the first spouse's death by law. However, most Americans reside in separate property states. As such, those states do not have community property and their citizens do not receive a step up in basis at the first spouse's death. Accordingly, Tennessee created the Community Property Trust to give their citizens (or out of state citizens who utilize this trust) the same tax advantage as those residing in community property states.
What happens to Community Property Trust assets if you get divorced?
If you have a Community Property Trust with your spouse and you subsequently get divorced, be aware that all property in that trust must be split 50/50 between you and your spouse. This division is mandated by Tennessee law. So before you create a CPT, make sure that you and your spouse clearly understand the consequences of dissolving the trust in the event of divorce.
Are Community Property Trusts an Option Outside the State of Tennessee?
Yes. You can put out of state property into a Tennessee Community Property Trust so long as you have a Tennessee Trustee. That Trustee must be a resident of this state or be a corporate fiduciary located in Tennessee. For example, if you had lake house in Kentucky or a beach home in Florida and wanted to put that property into a CPT, you may do so as long as one of the Trustees is a Tennessee resident. Additionally, if you live in Mississippi or Georgia and want to create a Tennessee Community Property Trust for your home in your state, you can do so so long as you have one Tennessee Trustee.
The Last Word
Tennessee Community Property Trusts are a great tool to help avoid capital gains tax. CPTs can save you thousands of dollars in taxes if they are properly set up and funded. In many ways, it makes more sense to use a Community Property Trust in many circumstances than a basic revocable trust. If you are considering creating a CPT, it's best to give us a call. We are happy to walk you through the pros and cons of this unique trust and help you determine if it would be a right fit for your estate plan.