Part of creating an efficient estate plan is to protect family wealth, avoid probate, make things easier for heirs, and to also look for tax advantages, where possible. While most people want to accomplish these goals, a recent law change allows Florida residents a new advantage – the Florida Community Property Trust (“FLCPT”). This trust is a great way to plan your estate for a certain number of people after due consideration and research.
You will want to read this article if you:
- Are married and in a stable relationship
- Own significant assets that have appreciated substantially in value, such as stocks, your homestead or real estate; and
- You are looking for income tax planning opportunities for the potential sale of these assets. Specifically, if one spouse passes, all property characterized as community property assets get a 100% step-up based on the first spouse's death.
In This Article:
Selling Assets to Result in a Capital Gain
Most of us do not have to worry about the estate tax. As of 2023, each US resident may pass some $12.92 million, tax-free, upon their death. This amount doubles for a married couple. This means that probate avoidance and income tax planning – specifically capital gains planning - may create more planning opportunities for several people who do not have taxable estates.
In estate planning, there are many practical reasons why one would need to sell an asset, resulting in a capital gain. For example, you may want or need to:
- Reduce your exposure to risk by selling assets tax-free upon a spouse's death
- Get out of a concentrated position
- Not want to manage real estate anymore
- Take advantage of current market conditions
- Simplify your estate plan and management of your assets
What is Cost Basis?
To understand how capital gains are calculated, we should first briefly explore the concept of basis. In short, cost basis is equal to the purchase price paid to acquire a capital asset, subject to certain upward and downward adjustments made for additional improvements and depreciation, respectively. When a capital asset is sold, the difference between the sales price (presumably, fair market value) and the cost basis (subject to adjustments) is treated as a capital gain or loss depending on whether the fair market value is greater than or less than the cost basis. The federal tax rate applied to capital gains varies depending on filing status and the taxpayer's applicable adjusted gross income bracket.
How are Capital Gains Calculated?
Any depreciation taken on the asset reduces the cost basis, resulting in additional tax liability to “recapture” and offset any previous depreciation deductions. The example below illustrates capital gains' effect on the net proceeds received from a transaction and exemplifies why many individuals are reluctant to liquidate capital assets.
Example 1: The following example assumes the taxpayer is a married couple filing jointly:
|Adjusted Gross Income||2023 Capital Gains Tax Rate|
|Recapture Tax Rate|
|Net Investment Income Surtax Rate|
|3.8% (NII applies if adjusted gross income exceeds $250,000)|
Assume Stan and his wife Patrice own an apartment building in Florida that they purchased for $200,000 in 1975. The current fair market value of the property is $5,000,000. If they sell the property, they will have a taxable gain of $5,000,000, assuming the property is fully depreciated. Of the $5,000,000 gain, $200,000 will be treated as depreciation recapture and taxed at federal recapture rates. They have more than $250,000 in other adjusted gross income, meaning the net investment income surtax rates will also be applicable.
|20% Federal capital gains tax (on $4.8 million)||$960,000|
|25% Depreciation recapture tax (on $200,000)||$50,000|
|3.8% NII surtax (on $4.8 million)||$190,000|
|Total Taxes Incurred on Sale||$1,200,000|
As we see, capital gains taxes can have a detrimental impact on a potential sale of a capital asset. Thus, the basis the taxpayer has in selling property plays a vital role in determining to what extent capital gains tax will be incurred. Generally, it is most desirable to have a basis that is as close as possible to, if not equal to, the fair market value of the sold property.
Under the Internal Revenue Code (“IRC”) §1014(a)(1), property inherited from a decedent receives a basis equal to the fair market value of the property as of the date of the decedent’s death. This is commonly referred to as a “step-up” in basis if the asset has appreciated since the initial acquisition by the decedent. If the converse is true and assets have depreciated this is known as a “step-down” in basis.
The Florida Community Property Tax Advantage
The portion of property to which the basis step-up is applicable depends on the jurisdiction. A majority of states in America have adopted the English common law concept of separate property. Under this regime, property acquired by a married individual will remain separate property unless agreed upon otherwise. A married couple could have property owned jointly in a separate property jurisdiction (usually as tenancy by the entirety). For the application of IRC §1014(a)(1), the surviving spouse would only receive a basis step-up on the decedent’s separate one-half interest. A subsequent sale of the property would reflect a basis equal to one-half of the property's fair market value at the decedent’s death, plus the current adjusted basis the surviving spouse had in the property, if any.
Nine states (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin) are community property jurisdictions. As of 2022, Florida allows individuals to opt-in to those states’ elective community property regimes. Community property is derived from French and Spanish law whereby property acquired by either spouse during a marriage vests a one-half interest in the property to each spouse as community property.
Under IRC §1014(b)(6), a special basis rule applies to community property states. Upon the first spouse's death, the surviving spouse receives a basis step-up in both the decedent’s one-half interest in the community property and the surviving spouse’s one-half interest in the community property. A subsequent sale of the property would reflect a basis equal to the fair market value of the entire property at the decedent’s death (as opposed to a basis step-up of only the decedent’s one-half interest of property as is the case in separate property states).
Assuming the asset is depreciable, not only does the step-up in basis eliminate or significantly reduce any capital gains tax liability, but it also allows the surviving spouse to generate additional depreciation deductions starting from the fair market value of the property as of the decedent’s date of death, thereby providing an additional offset of income from other sources. The following example illustrates the financial benefit that §1014(b)(6) affords individuals owning property in community property jurisdictions versus those owning property in separate property states.
Example 2: Stan and Patrice paid $1,000,000 for ABC stock, titled tenants by the entirety in a separate property jurisdiction. If Stan dies in 2015 and all of the stock is worth $2,500,000, Stan’s one-half interest gets a step-up in basis to $1,250,000. Patrice’s basis in her one-half interest is still $500,000. If Patrice sells all of the ABC stock for $2,500,000, then her total basis is $1,750,000, resulting in a gain of $750,000. If, ignoring the 3.8% Net Investment Income Surtax and depreciation recapture, a 20% capital gains tax rate is assumed, Patrice has $150,000 in tax liability.
But if Stan and Patrice owned the ABC stock as community property, then when either spouse dies, the entire amount of the stock receives a step-up in basis to the fair market value, (i.e. $2,500,000). If the survivor sold the stock for $2,500,000, no capital gain would be incurred.
Recognizing the income tax benefits of owning community property and the potential to generate revenues for the state, the Florida legislature (and Alaska and Tennessee) enacted laws allowing both residents and non-residents alike to opt-in to a community property regime. Florida law now allows for creating a community property trust whereby you can convert that separate property (i.e., Florida property) into community property by transferring ownership to a Florida community property trust.
The Requirements for Creating a Florida Community Property Trust
The specific rules to creating a Florida Community Property Trust is as follows:
- A declaration in the trust document that the trust is a Florida Community Property Trust;
- At least one qualified trustee (which means a resident of Florida or a qualified bank or trust company located in Florida);
- Signatures of both spouses; and
- Specific “warning” language in capital letters to be inserted at the beginning of the trust document.
Community property trusts work well in conjunction with estate plans that have already been implemented. Assuming that a couple has already created separate or joint revocable trusts, appreciated property currently owned by the revocable trust or by the spouses individually would be transferred into a new community property trust. At the first spouse's death, when the allowable basis adjustment occurs under §1014(b)(6), the community property would be divided. Half of the property would be distributed according to the deceased spouse’s estate plan, and the other half would be distributed to the surviving spouse either outright or into a structure consistent with the survivor’s estate plan.
Importantly, community property trusts are not a “one-size-fits-all” solution. Community property trusts are generally for couples who have one or more of the following characteristics:
- They are in a long-term, stable marriage;
- One or both individuals own highly appreciated property, stocks, real estate or business interests;
- Their financial portfolio has significant appreciation or are heavily weighted in a few stocks, which they are reluctant to liquidate because of exposure to capital gains tax;
- They have rental real estate the likely survivor does not want to manage and will liquidate; and/or
- The Trustee of the FLCPT must live in Florida or be a corporate Trustee in Florida.
Despite the tremendous income tax benefits that community property trusts may offer, these structures carry several risks, such as:
- Assets in a Florida Community Property Trust are not entirely protected against one spouse’s creditors. In Florida, property that is owned as tenancy by the entirety (i.e. jointly with a married couple) cannot be levied by the personal creditors of the debtor spouse. With assets in a CPT Trust, the creditor of one spouse can levy against one-half the community property assets in a CPT trust.
- Finally, the Internal Revenue Service’s position concerning elective community property regimes with respect to tax basis has not been affirmatively established. While many arguments exist that the IRS will respect community property in a common-law state to be treated as community property, no case firmly establishes this point. The absence of definitive case law or a revenue ruling creates some risk for the practitioner that the nature of the transaction will not be respected, and thus, the tax of an FLCPT advantage is thwarted.
Regular Joint Living Trust or a Community Property Trust?
Our law firm, like many law firms, frequently create joint living trusts for a married couple. This planning is done to avoid probate if both spouses pass away. It is good planning to get your affairs in order as we can never tell the order of death, or if a joint accident occurs. But most joint living trusts are NOT community property trusts. It may be that community property trusts are the best way to go for married couples that have highly appreciated assets, such as a homestead property. If one spouse passes, the surviving spouse can sell the home or othere property tax-free as the community property in the trust gets a 100% step-up in basis.
If you want to create a FLCPT, you cannot use your existing joint living trust. A new FLCPT would have to be created from scratch. But this recent addition to Florida law may be worth it in the right situation.
Schedule a Consultation With Our Seminole Estate Planning Lawyer to Learn More
If you want to learn more about creating a FLCPT, our law firm will gladly review this with you. The best way to do this is to click the button below or call us at 727.777.6842 to schedule a consultation with our experienced estate planning lawyer in Seminole, FL.