Community Property: What Investors Need To Know

You can't be a great real estate investor if you don't have an understanding of marital property laws and how they affect your investments. Most U.S. states use common law, also known as or equitable distribution, as their matrimonial regime, but in Texas and eight other states, community property is the rule.

What is Community Property?

The principle of community property is that each spouse owns half the couple’s assets. It assumes that every contribution each spouse makes to the "marriage community" should be shared.

This means property, income, and other assets acquired by either spouse during the marriage belongs equally to each of them. It also means that in the event of death or divorce, each spouse gets an equal share of the property.

And before you ask me, yes, it also means that both spouses are accountable for the other’s debts.

Some exceptions apply to allow sole ownership of a property or certain assets:

Property and other assets owned by either party before their union
Gifts or inheritance bequeathed solely to one spouse
Property bought or exchanged with separate funds or property

Property one spouse acquired before the marriage remains that person’s sole property, unless it transmutes, or changes, to community property by:

The other spouse contributing to the mortgage
As a gift, or by mutual agreement between both spouses

It is important to note that in Texas and Idaho, income earned from separate properties is considered community property. In the other community property states, such income is considered separate. That bring me to our next section ...

What Are The Community Property States?

Community property is the law in the following states:

Arizona
California
Idaho
Louisiana
Nevada
New Mexico
Texas
Washington
Wisconsin

Out of the nine states that use community property instead of common law, Texas is the only community property state that recognizes common-law marriages (not to be confused with common law property). In the other states, only legal marriages pertain to community property.

Property rights in some states, including Texas, may come into play in partnerships that resemble traditional marriages, e.g. by length of cohabitation or the raising of children together. Where separate ownership cannot be ascertained, the court m

ay rule on an equitable split, which is partly depending on how much each spouse contributed financial assets to the marriage (e.g. 40/60 or 30/70 instead of 50/50.) In California, the split must be 50/50.

Which State Has Jurisdiction Over Your Investments?

For most people, it's an easy-to-answer question. Where do you live? Is it in a community property state or not?

But for may of us who invest in assets all over the country or all over the world, we have to look at other factors.

Yes, domicile, a person’s legal permanent address, is used to define where a couple lives, and therefore which state’s jurisdiction their property law comes under. This becomes important for couples that end up in the divorce courts if they have homes in more than one state, or are on the move regularly, e.g. from being in the military, or temporary work placements.

Some factors used to determine domicile include:

Where the person registers to vote
Where a person registers their vehicles
From where they file their tax return
Where their family lives.

The Tax Benefits of Community Property

Community property has several tax benefits. In the event of the death of one spouse, both partners’ interest in the property get a "step-up" in basis. The property gets an updated tax basis on the market valuation at the date of their death. The deceased spouse legally has a half interest in the entire community property, so both halves of the property receive the step-up in basis, instead of just the deceased’s half.

Say a couple own a house with a basis of $50,000, the amount they initially paid. The house now has a value of $500,000, making each spouse's’ share of the house worth $250,000 with a basis of $25,000. The deceased spouse’s share now has a basis of $250,000. If the property were not community-owned, the living spouse’s share’s basis would remain at $25,000, and the total basis $275,000. In a community property state, each half would get the new basis of $250,000, giving a total basis of $500,000.

Marital Agreements Mean Fewer Headaches

While community property has some tax benefits, it is easy to see the downsides to the system. But there are ways to protect your assets. When it comes to the potential for divorce, one way to avoid complications from community property laws is to draft a marital agreement, a.k.a. a "prenup."

A prenuptial, post-marital, or divorce agreement can convert community property into separate property in the event of death or divorce. Some states allow you to opt-out of the system without a pre-signed agreement, but others, such as California, are stricter, and there is the chance other states may follow suit. So it is best to sign a formal agreement under any jurisdictions.

When Might There Be A Dispute?

Disputes can arise upon the death of a spouse, particularly if children are involved. Typically, if somebody dies without leaving a will, their half of the estate goes to the remaining spouse unless they had children from a previous relationship. In which case, the remaining spouse retains their half, but the deceased spouse’s half goes to his or her children.

Estate planning and making a will can help you or your family avoid extra stress in times of loss.

What Happens In Cases of Bankruptcy?

In community property states, if one spouse needs to file for bankruptcy, it must include all community-owned property. In many cases, judges will require the other spouse to declare bankruptcy too. Creditors can make claims against community property, and even against the other spouse’s individually owned properties.

It is possible to obtain a community-property discharge, which means a creditor can no longer go after a community owned property.
This exemption also protects the spouse who did not file for bankruptcy and their separately owned properties.

Trusts and Dower Rights

Placing your property into a trust has several benefits.

It protects your assets while you are alive.
It makes the probate process faster once you have passed away, taking up less time and legal fees for your heirs.
Offshore trusts in certain jurisdictions provide the most protection.

Three states still have Dower Rights for spouses not on the title to a property. In Ohio, Kentucky, and Arkansas, a widow or widower is entitled to the interest or income from one-third of their deceased spouse’s property.

California land trusts aren’t subject to community property or dower rights, so are a great way to invest without the risk associated with the usual marital property laws in California.

Can I Use a Land Trust in California to Protect Real Estate Assets?

Does California recognize land trusts? Yes, but California real estate investors face certain regulations and restrictions in their home state.

Land trusts (read: What Are Land Trusts?) are not subject to the same burdensome tax obligations as, say, an in-state LLC. In fact, the fact that they are relatively new means that there isn't much law about them at the state level at all. Keep reading to learn more about using a land trust in California, as well as what specific benefits Golden State investors can enjoy when they do so.

California Land Trusts Are New

The novelty of land trusts in California actually confers some benefits onto their owners. Other states with more established case law have more exceptions to the protections of land trusts. In general, law is built on precedent. This means that court decisions aren't made in a vacuum. They are heavily informed by the rulings of past courts, particularly courts in the same area.

California Land Trust Community Property Advantages

California is a community property state. This is most relevant for married real estate investors. In community property states, anything one party gains during a marriage can be legally treated as a joint asset.

Community property laws come up frequently in the unfortunate event of a divorce. Let's look at an example. John and Mary Smith are real estate investors in the San Francisco area who have been married for ten years. They both have their own investments, but Mary is the more prolific investor. They show up in family court after a mutual decision to end their marriage.

With no asset protection measures or land trusts in place, Mary could actually stand to lose some of the investment properties (or even the money she would receive from them if they are sold) in the divorce. However, if she uses a land trust to hold the properties, this is unlikely to happen.

The land trust itself is controlled by a trustee, and therefore will not be treated as community property. In short, Mary would be in a much better situation using a land trust because John has a legal ability to make claims on property with her own name on it. He does not have this ability if the property is held in an anonymous land trust.

Of course, there are ways around state regulations that confer community property status onto assets gained during a valid marriage. Tenancy by the Entireties, also called TbyE, allows married couples to own a piece of real estate together, but not jointly. Some couples elect to use both methods of protection by both securing shared properties in land trusts and owning them TbyE.

This information may seem a touch cynical. Few people, when marrying, ever believe they will end up dealing with the fallout of divorce. But the unfortunate truth is this: over half of marriages do end in divorce.

When it comes to the law, it's perfectly fine to hope for the best. But the smart investor will always prepare for the worst. The wise investor plans ahead to avoid the worst possible outcomes, like lawsuits and losing property in a divorce.

Royal Legal Solutions is Here To Help Investors Like You

Royal Legal Solutions works with real estate investors from all over the country. We keep up with the latest changes in state law and other legal technicalities so that you don't have to. We are also well aware of and sensitive to the needs of California investors. Whether you're trying to enjoy the tax benefits or asset protection aspects of a land trust, we can help.