In 2020, the Kentucky General Assembly passed a new law that allows for the creation of a Kentucky Community Property Trust that helps reduce capital gains tax for married couples. This type of trust can save married couples in Kentucky thousands of dollars they would otherwise incur when property or other assets are sold.
In this article, we will break down how capital gains tax works and how a Kentucky Community Property Trust can save couples from this tax at the death of the first spouse.
Capital Gains Tax – How It Works
In order to properly understand how a Kentucky Community Property Trust operates, it is helpful to first review how capital gains taxes work.
Capital gains taxes are taxes that accrue when asset appreciation is realized. This occurs when a capital asset is sold at a higher value from what it was originally purchased for, resulting in a gain. What you pay for something is known as a basis, in tax lingo. So, if you purchase an asset for $100,000 that is your basis in the property. Similarly, a basis can also be established when you inherit an asset. As an example, if you inherited a property that is worth $300,000 then your basis in the property is $300,000. The Federal government measures capital gains based upon the difference between your basis in the asset versus the price for which you sell it.
There are a few different capital gains tax rates for individuals. A long-term capital gain is realized when a capital asset is held for more than a year. In 2022, long-term capital gains are usually taxed at 15% with individuals who make over roughly $41,000 in income per year and for couples who make over approximately $81,000 per year. Individuals making under these amounts would have no capital gains on the sale of their asset.
A short-term capital gain is realized upon selling a capital asset which was held for under a year. A short-term capital gain is taxed at the individual’s personal income tax rate. For example, if you are in the 22% income tax bracket, you will pay capital gains tax at a rate of 22% on your gain.
Let’s take a look at the following example to help briefly illustrate capital gains:
Scenario: A husband and wife own a piece of property which they bought for $100,000. Over a ten-year period, the property’s value increased, and the property is now worth $200,000. If the property is now sold for $200,000, the couple will have to pay a minimum of 15% tax on the proceeds of the property, or $15,000 in capital gains taxes on the $100,000 realized gain (assuming they make over $81,000 together as a married couple).
What Is a Step-Up In Basis?
A step-up in basis occurs when an asset with a lower basis is increased to a new, higher basis. This step-up occurs when an individual dies and passes property on to their heirs or beneficiaries, typically their children or other loved one.
Here is an example of how a step-up in basis is achieved:
Scenario: A mother owns property she purchased in 1990 for $100,000. The $100,000 purchase price is mother’s basis in her property. In her will, mother leaves the house to child. When mother dies, the house is worth $300,000.00. The child now receives a “step-up” in basis to the fair market value of the property at mother’s death, in this case $300,000. Because of this, if the child sells the property for $300,000, the child will not incur any capital gains tax because she is selling the property at her actual basis.
Capital Gains Tax for Jointly Owned Marital Property
Married couples in Kentucky do not have the same step-up in basis on jointly owned property. These couples only receive a half step-up in basis at the first spouse’s death. As such, if property is sold after one spouse’s death, the surviving spouse would still incur capital gains tax if sold at a gain.
Here’s an example of how it works:
Scenario: If a wife dies, and the husband decides to sell the property, the husband only receives a half step-up in cost basis. Let’s say the original basis was $100,000 and the property is now sold for $300,000 at the wife’s death. The realized gain is $200,000. What is husband’s new basis?
In order to calculate the half step-up in cost basis, we take the original basis and add it with the fair market value of the property at wife’s death then divide by two.
So, in this example: $100,000 + $300,000 = $400,000. We then divide the total of $400,000 by 2 which equals $200,000, establishing husband’s new basis. If the husband now sells the property he would only pay capital gains tax on $100,000 gain ($300,000 – $200,000 = $100,000). Assuming there is a 15% capital gains tax, the actual tax would be $22,500 (15% x $100,000 = $15,000).
Despite the half step-up cost basis in this scenario, the amount of taxes being paid could have been prevented if the couple would have placed their property in a Kentucky Community Property Trust.
How A Kentucky Community Property Trust Works
A Kentucky Community Property Trust (CPT) is a type of trust that allows married couples to place assets into a trust in order for the surviving spouse to receive a full step-up cost basis in the assets upon the first spouse’s passing. The basis is determined by the market value at the time of death of a spouse. This complete step-up in basis substantially minimizes the amount of capital gains taxes realized on capital assets placed into the CPT if said assets are subsequently sold.
Scenario 1: If a couple has a property basis of $200,000 in a community property trust and the husband dies shortly thereafter, the wife will receive a complete step-up cost basis to the market value of the property, which may be several hundreds of thousands of dollars. If the wife decides to sell shortly thereafter, she will pay no capital gains tax if the property is sold at market-value.
Scenario 2: If you purchase 1,000 shares of stock in 2020 for $5 per share (for a $5,000 investment) and that stock is now worth $100 per share, the fair market value of your investment is $100,000. You have a gain of $95,000. As such, if you sold the stock today, you would pay $14,250 in capital gains taxes.
However, if that stock was held in a Kentucky Community Property Trust, your spouse would receive a complete step-up in cost basis to the market value of the stock at your death. If the stock is then sold, there would be no capital gains tax.
CPTs are commonly used with real estate investments, stocks, collections, and digital assets such as cryptocurrencies that have had substantial capital appreciation. These types of trusts can also be very beneficial when one spouse is the primary person managing certain assets the trust holds.
Scenario 1: If a husband and wife have several rental properties in which the husband primarily manages the properties himself, the wife may wish to sell the properties upon the death of her husband. A community property trust would allow the wife to receive a step-up basis at the death of her husband. This trust would help wife avoid paying virtually any capital gains tax if sold shortly after.
Scenario 2: Assume husband and wife run a small business. Husband is an owner, but he is not involved in the business and plans to close the business should something happen to wife. If wife died, husband would receive a step-up cost basis at the wife’s death on the value of wife’s business, resulting in little to no capital gains taxes if the husband sells the business to a third party.
Note on personal residences: Your personal home has a built-in capital gains tax emption. Meaning there are no capital gains taxes paid on your personal home up to a certain limit. The exemption limit for married couples is currently $500,000 while the individual exemption is $250,000. Under these exemptions, if your capital gains from your personal residence is less than $500,000 or $250,000, then there are no capital gains taxes. This exemption only applies to your personal residence, not investment properties or vacation homes and is subject to a few other requirements.
Creating a Kentucky Community Property Trust
The process of creating a Community Property Trust is similar to the creation of a basic revocable trust. When a CPT is created, the creator transfers property into the trust. The creators, commonly known as the grantors or settlors, are co-trustees during their lifetime. Co-trustees control any and all property within the CPT and may use the property within the trust for their benefit just as if they personally owned it.
Community Property Trusts were created by Separate Property states (Kentucky), to allow couples in Kentucky achieve the same tax benefits that couples in other community property states such as Texas, Florida, and California enjoy with the IRS. Separate Property states do not have the same laws that allow a surviving spouse to receive a step-up cost basis. As discussed, surviving spouses only receive a half step-up in basis on jointly owned property. Because of this, the Kentucky Legislature created the Community Property Trust to give its citizens the same tax advantages as those residing in community property states.
What Happens to Community Property Trust Assets If You Get Divorced?
One of the major downsides to the Kentucky Community Property Trust is that Kentucky law mandates that if you and your wife have a CPT and subsequently divorce, all property within the trust must be split 50/50 between you and your spouse, regardless of who previously owned the property. Before creating a CPT, make sure you and your spouse fully understand the consequences of dissolving the trust by divorce.
Kentucky Community Property Trusts with Out of State Property
Kentucky Community Property Trusts can hold out of state property so long as there is a qualified Kentucky Trustee. That Trustee must be a resident of this state or be a corporate fiduciary located in Kentucky. For example, if you had a cabin in the Smokey Mountains, or a beach home in the Florida Keys, you could place both properties within the CPT, as long as one of the Trustees is a resident of Kentucky. Additionally, if you lived in another state, and wanted to create a Kentucky Community Property Trust for your home in your state, you can do so only if you have a Kentucky Trustee.
Kentucky Community Property Trusts are a great way to minimize or even prevent capital gain realizations. CPTs can help save thousands of dollars if they are properly created and funded. In some circumstances it makes more sense to create a Community Property Trust than a basic revocable trust. If you are considering creating a CPT, it’s best to give us a call. We are happy to help guide you through the benefits and disadvantages of this unique trust and help you determine if it would be a right fit for your estate plan.