March 01, 2015

A New Trend in Estate Planning?

Jay A. Soled

Many people will go to great lengths to minimize their taxes, including changing their domicile. In the past, this strategy of changing domicile to avoid the application of state estate tax could yield significant tax savings. For example, a taxpayer who was worth $5 million in 2013 and who moved her domicile from New York to Florida could save hundreds of thousands of dollars in estate taxes. These estate tax savings lured many taxpayers to shun high-state-tax jurisdictions—even at the personal sacrifice of having to pick up and move themselves and their families.

But the vast majority of states have eliminated estate taxes or greatly curtailed their application by raising exemption amounts to equal the federal threshold (currently, $5.43 million). In many instances, this has reduced the tax incentive to change domiciles. Or has it?

There may be a new trend on the horizon, one in which some taxpayers may purposefully relocate to community property states. Primarily in the West, such states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. What is the tax attraction of these states relative to common law property states? It’s simple: for property owned by married couples, upon the death of one spouse, the adjusted tax bases of all their properties, and not just the property held in the decedent spouse’s name, are deemed equal to fair market value.

To illustrate, consider the following example concerning two pieces of appreciated property. Suppose a husband and wife each own one. Assume each piece of property has a $300,000 tax basis and $1 million fair market value. In a community property law state, if the husband dies, the wife would be deemed to own both pieces and each would be accorded a $1 million tax basis under the Internal Revenue Code. The wife could therefore subsequently sell both and experience no gain. In contrast, in a common law state, the tax basis only in the property owned by the decedent husband would equal $1 million and the wife’s tax basis in the property she owned would remain at $300,000. If the wife sold this latter property for $1 million, she would experience a gain of $700,000 ($1 million minus $300,000), and the accompanying federal and state tax liability could easily exceed a quarter-million dollars.

Will the potential increase in tax basis that community law states offer entice taxpayers to change their domicile? The answer is unclear and depends upon personal circumstances. When taxpayers do not have significantly appreciated assets (e.g., cash or bonds), do have property with embedded losses, and/or the husband and wife intend to hold all their properties until their mutual demise, community property states will not prove enticing. Conversely, if a married couple residing in a common law state has a lot of appreciated assets and the intention is that the surviving spouse will sell some or all of these assets after the death of the first spouse, changing domicile from a common law state to a community property state may prove alluring.

Relocating to another state is never easy. It typically engenders an upheaval in one’s life. Historically, if it reduces their tax burdens, many taxpayers have been willing to bear this undertaking; time will tell, however, if the tax-basis virtue that community property states offer proves attractive enough to begin another migratory trend.

Jay A. Soled

Jay A. Soled is a professor at Rutgers University in Newark and the editor of the SLD book, Estate Planning Strategies: A Lawyer’s Guide to Retirement and Lifetime Planning. The information in this article is intended as general information only and should not be acted upon without professional advice.