I. BACKGROUND.
FOR HAWAII CLIENTS
A. Community property is a regime of marital property that traces it roots to civil law systems.1. Most property acquired during marriage is owned jointly by both spouses and divided equally in the event of divorce, annulment or death, no matter what the actual title of the asset may be.
2. Community property rules generally do not apply to property acquired prior to the marriage or to property acquired by gift or inheritance during the marriage.
3. Division of community property may take place by item, by splitting all items or by value. In some jurisdictions, such as California, an equal division of community property is mandated by statute. See California Family Code Sec. 2550.
4. There are 10 community property states, mostly in the west: Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. The two most populous states, California and Texas, containing almost 20% of the U.S. population, are community property states.
5. The laws between the community property states differ widely, such as:
a. In some community property states (so-called “American Rule” states), income from separate property is also separate. In others (so-called “Civil Law” states), the income from separate property is community property.
b. The right of a creditor to reach community property in satisfaction of a debt or other obligation incurred by one or both of the spouses also varies from state to state. For example, Division of community debts may not be the same as division of community property. For example, in California, community property is required to be divided “equally” while community debt is required to be divided “equitably.”
B. Common law marital property is a regimen that traces its roots to common law. This regimen is sometimes referred to as “equitable distribution.”
1. This means that a decedent’s asset will go to whomever they have stated in a Will or Trust, with the exception of the spousal election rights of the surviving spouse.
C. Many Hawaii lawyers know there are community property states, but do not really know what this means, do not understand the rudiments of this form of property ownership, and thus often do not grasp the implications of the issues involved for clients who move to Hawaii from community property states. Many Hawaii lawyers and estate planning professionals may simply ignore the implications of community property for their clients from community property states.
II. BASIC ISSUES FOR CLIENTS MOVING FROM COMMUNITY PROPERTY TO COMMON LAW PROPERTY STATES.
A. When a husband and wife move from a community property state to a common law state such as Hawaii, the general rule is their community property, as well as the property they acquired with community funds (and property traceable to those funds), continues to be community property, despite the fact that the couple lives in a common law state.
1. Under Restatement (Second) of Conflicts of Laws Section 259, when a couple or spouse acquires an asset, the fact that the couple or spouse moves to another state does not affect the character of the property.
2. According to comment (a) to Section 259 “Considerations of fairness and convenience require that…the spouses’ marital property interests are not affected by a change of domicile to another state by one or both of the parties.” Comment (b) adds “If one or both spouses sell the property in their domicile and reinvest the proceeds in another asset, the new asset purchased with the proceeds retains the character of the original.”
B. The Uniform Disposition of Community Property Rights at Death Act (UDCPRDA) has been adopted by Hawaii. States that have adopted the UDCPRDA recognize and preserve community property brought from a community property state to a common law state for purposes of rights of disposition at death. The Act applies to:
1. Personal Property. Personal property that was acquired as, or became, and remained community property under the laws of another jurisdiction, or that was acquired with income or proceeds from community property, or is traceable to community property.
Example: H and W, while domiciled in Wisconsin, a community property state, purchased 100 shares of stock each of A Co., B Co., and C Co. with marital property (the earnings of W). H and W then moved to Illinois, a common law, non-UDCPRDA state. While there, W sold 100 shares of A stock and used the proceeds to buy 100 shares of D stock. H and W then moved to Hawaii, a common law, UDCPRDA state. W then sold all of the B stock and 50 shares of D stock and purchased 150 shares of E stock with the proceeds. W died in Hawaii with 100 shares of C stock, 50 shares of D stock, and 150 shares of E stock. All of the shares, traceable to community property or the proceeds therefrom, are subject to the Act. Therefore, W may dispose of 50 shares of C stock, 25 shares of D stock, and 75 shares of E stock. However, as discussed below, all 300 shares receive new basis under IRC Section 1014(b)(6).
2. Real Property. Real property purchased in the UDCPRDA state with community property brought into the UDCPRDA state is community property.
Example: H and W move from California, a community property, non-UDCPRDA state, to Hawaii, a common law, UDCPRDA state. They retain their residence in California. Using $800,000 of community property funds drawn from their California bank account, and $200,000 earned by H after arriving in Hawaii, H and W also purchase a home in Hawaii. On H’s death while domiciled in Hawaii, 80% of the Hawaii home is subject to the Act. The California residence is not subject to the Act.
3. Assets acquired with community property. Note from the above examples that in a UDCPRDA state, personal property acquired with community property wherever located, and real property acquired with community property in the UDCPRDA state, is community property.
4. The Act only affects dispositions at death, therefore:
a. Creditor rights are not affected;
b. Managerial rights are not affected; and
c. Division upon divorce is not affected.
5. Rebuttable Presumptions.
a. States that have enacted the UDCPRDA operate under a rebuttable presumption that:
(1) Personal property acquired during marriage in a community property jurisdiction is community property, and
(2) Real property situation in the UDCPRDA state and personal property wherever situated acquired while domiciled in a common law state, title to which was taken with rights of survivorship, is separate property.
(3) Example: H and W, formerly domiciled in Texas, became domiciled in Hawaii and there purchased a residence, taking title in the names of “H and W as tenants by the entirety” or “H and W as joint tenants with rights of survivorship.” Regardless of the source of the funds used to purchase the residence, the Hawaii residence would be presumed to be held in joint tenancy and thus not subject to the UDCPRDA.
III. RECOGNITION OF COMMUNITY PROPERTY IN HAWAII.
A. HRS Chapter 510 addresses issues of community property in Hawaii.
1. Hawaii is not by default a community property state. However, it does recognize community property principals and will enforce them.
2. HRS Section 510-2 states that one spouse may give all of their “community right, title, interest, or estate in all or any community property, real or personal,” to the other spouse. However, each such transfer made operates to divest the property of every claim or demand as community property, and vests the same in the transferee as separate property of the transferee. Therefore, a California couple that owns property in Hawaii must make it very clear that they want community property rights to attach to the property, but since such a type of joint ownership is not automatically considered community property (as it would be in California), there is no easy means to do so.
a. Add language in the acquisition deed that the property is to be treated as community property under the laws of the relevant state.
b. Hold title in the property in a community property joint trust.
B. If, on the other hand, a couple from California relocates to Hawaii on a permanent basis, it is unlikely they are told by a Hawaii attorney to keep their community property joint trust.
1. Because Hawaii is separate property state, most Hawaii attorneys suggest that California couples should redraft their estate planning documents which would effectively negate their community property joint trust because most, if not all assets, would be transferred from the joint trust to separate revocable trusts, as is the common practice in Hawaii.
2. There may be very important reasons to keep the community property nature of assets, even for a couple that has permanently relocated to Hawaii. See below discussion regarding estate tax considerations.
a. If this is the case, then an attorney could have some big liability issues, should have a plan of action:
(1) The ideal situation would be to keep the community property joint trust in effect in Hawaii, or at least with regard to certain assets (there are fewer problems with cash or non-low basis assets).
(a) The problem with this is that if a client wants to make changes to their community property joint trust, is an attorney practicing California (or other State) law without a license? If you amend a community property trust, there is an implication that you have reviewed, understand, and agree with the language of the community property trust.
IV. ESTATE TAX CONSIDERATIONS.
A. IRS Publication 555.
1. In community property states, each spouse usually is considered to won half the estate (excluding separate property). When the first spouse dies, the total fair market value of the community property, generally becomes the basis of the entire property. For this rule to apply, at least half the value of the community property interest must be includible in the first spouse to die’s gross estate, whether or not the estate must file a return. In other words, for community property, you get a step-up in the basis of the entire asset.
a. Example: H and W owned community property that had a basis of $80,000. When H died, H and W’s community property had a fair market value of $100,000. One-half of the fair market value of their community interest was includible in H’s estate. The basis of W’s half of the property is $50,000 after H died (half of the $100,000 fair market value). The basis of the other half to H’s heirs is also $50,000.
B. In non-community property, joint ownership states, the law is different.
1. Example: H and W are domiciled in Hawaii and own all of their assets as either joint tenants with rights of survivorship, or as tenants by the entirety. Upon H’s death, only one-half of the asset’s basis, the portion allocated to H, is stepped-up to the date of death value. So using the same example above, one-half of the property has a basis of $50,000, and the W’s share of the asset has a basis of $40,000.
C. Estate Planning Techniques for Imported Community Property.
1. Consultation with Community Property Attorneys. Many lawyers in Hawaii may want to consult an attorney in the community property state from which their new clients have migrated. Community property attorneys have a much better working knowledge of the issues. However, the following basic guidelines may prove helpful in forming planning strategies.
2. Retaining Community Property Character of Assets.
a. Recognizing imported Community Property. The first step in retaining community property is recognizing that it is a potential issue. Hawaii attorneys, financial professionals and trust officers should include in their new client checklist:
(1) The date of the clients' marriage and their states of domicile (1) before the marriage and (2) since the marriage.
(2) If the answer to the second question includes one (or more) of the nine community and marital property states, the potential issue should be recognized immediately.
b. Segregating Community Property. In community property states, all property of a married person is presumed to be community property absent evidence to the contrary. In UDCPRDA states, such as Hawaii, this presumption applies to property acquired during marriage while domiciled in a community property state. However, this presumption does not necessarily apply in the remaining 27 states, even if the 'time of acquisition rule' is followed. Therefore, careful record keeping is essential to trace community property before it is commingled with separate property in the new state. Note that this mirrors record keeping requirements in community property states to segregate separate property.
(1) Separate Accounts. Advisors may consider segregating community property assets such as cash into separate community property accounts.
(2) Joint Revocable Trusts. Attorneys should consider the use of joint revocable trusts to hold community property assets.
(a) The trust should be funded during the Grantors’ lives with community property to protect its character from mixing with separate property.
(b) The Settlors should be both husband and wife.
(c) Income from property transferred to the trust should be designated as community property by the trust instrument.
(d) A simple joint revocable trust can be created to hold only the married couple’s community property. At the first spouse’s death, the trust will simply be divided into two equal shares. One share will pass to the husband’s separate revocable trust, and the other to the wife’s separate revocable trust (or one half to the estate of the deceased spouse, and the other half to the surviving spouse). To avoid a premature distribution for alternate valuation purposes, the trust instrument should permit the trustee to postpone dividing the trust into separate trusts and defer the outright distribution of assets to the beneficiaries for six months.
(3) (NOT) Retitling Assets. Care should be taken not to title assets in any form of joint ownership after the move to the common law state, such as tenancy in common, joint tenancy with rights of survivorship or tenancy by the entirety. In UDCPRDA states, such a form of ownership creates a rebuttable presumption that the property is separate property, regardless of its source. In all states, such changes in the form of ownership may convert community property into separate property.
(4) Executing a New Community Property Agreement. After the move to the common law state, spouses may want to execute a new community property agreement, designating which imported assets are to retain their community property character. In addition, the agreement can recite and document which assets were acquired after the move with community property. The Community Property Agreement can be part of the Joint Revocable Trust, or it can be an entirely separate document.
D. Special Issues Relating to Irrevocable Trusts.
1. Advisors must be very careful with respect to estate planning techniques involving irrevocable trusts and community property. A potential trap exists with respect to an irrevocable trust in which one of the spouses has either a beneficial interest or has control over the trust assets (e.g., one spouse is serving as trustee).
2. With respect to an irrevocable trust granting a beneficial interest in one spouse, the trap to avoid relates to the creation of a life income interest or similar right in one spouse where there is an irrevocable transfer of community property. In such a case, the transfer of community property would result in an impermissible retained income interest in the spouse, causing inclusion under IRC §2036. This can be a particular problem in life insurance trusts where the premiums are paid with community funds. Accordingly, practitioners must be very careful to counsel clients not to fund irrevocable trusts with community property where one spouse is also a beneficiary of the irrevocable trust.
3. Another problem exists where, for example, the husband creates an irrevocable trust for his children, naming his wife as the trustee. If the trust is funded with community property, and if the trustee has control over the timing of trust distributions, one-half of the value will be included in the wife's taxable estate under IRC §2038.
4. The remedy is, of course, to be sure that community assets are not used in funding trusts in the above-described situations. If there are no assets other than community assets available for funding, then the practitioner might be able to avoid the problems through the creation of separate property through transmutation (i.e., through a written agreement which reclassifies the assets as the separate property of the grantor's spouse) or through partition.
