When a couple walks into an estate planning attorney’s office, they typically arrive as a unit. They consider that “they” have assets and often don’t want to speak of “what if.” It takes a gentle touch to address the topic of divorce.
“It is not a lack of love, but a lack of friendship that makes unhappy marriages.” Friedrich Nietzsche
The estate planning attorney often is focused on the desire for simplicity which the clients expressed. In addition, the attorney may be thinking of step-up in basis and asset protection concerns. These are good things to consider. But, the potential downside in divorce should be considered and explained, as well.
For example, when a couple moves to a community property state, they have separate property from their time in a non-community property state. From an income tax perspective, it is typically better to convert all the property to community property. Community property gets a step-up in basis to fair market value at the death of either spouse. Separate property only gets a step-up on the property owned by the deceased spouse. However, if the property is converted to community property, each spouse has a right to one-half of the property. Let’s look at an example:
John and Mary lived in State A, a separate property state. John came into the marriage with $1 million and earned another $3 million during the marriage. Mary came into the marriage with $100,000 and was a stay-at-home parent. They move to state B, a community property state. If the property is left as is, when John dies his $4 million of property would get a step-up in basis and Mary’s $100,000 would not. Conversely, when Mary dies, her $100,000 of property would get a step-up in basis, while John’s $4 million would not. If they convert all their property to community property, all the property would get a step-up in basis at the death of the first of them to die.
However, if they were to divorce, Mary would have a right to ½ of all the property. While it is better from an income tax perspective to convert the property to community property, doing so would harm John’s rights in divorce.
If the couple were to equalize their estates or place it in tenancy-by-entirety while remaining in a non-community property state, a similar result would occur. There may be advantages in simplicity, asset protection, or taxation, but the rights of the richer spouse could be harmed. Thus, often it is a weighing of factors and this should be explained to the couple in simple terms, while using that soft touch.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555