Whenever you see something like “this one weird trick could save you tens of thousands of dollars in taxes” or “the secret tax loophole the IRS doesn’t want you to know about” you should usually run for the hills. That kind of come-on almost certainly indicates a scam.
But this column is about one legitimate trick which can, in many cases, save you tens of thousands of dollars (or even hundreds of thousands) on future taxes. And this one’s legit.
I'm sure I don't need to tell you that the federal tax laws are really complicated. When you make something really complicated, sometimes unintended consequences result. With the capital gains tax, the way the law is written, states that have community property laws actually get more favorable treatment than states that don't.
Let’s detour into a brief tutorial for those of you who are not familiar with the capital gains tax: This is the tax that applies when you sell something for more than you paid for it. To calculate the capital gains tax, you take the proceeds—what you got paid for it when it sold—and subtract the “basis,” which is what you paid, adjusted for things like improvements or depreciation. The tax is a percentage of that profit, the exact percentage depending on some other factors including how much you make, and how long you held that asset.
Back in the 1990s some sharp Alaska tax lawyers noticed that the nine states that have community property laws, were getting better treatment than the states that don't. Specifically, if a married couple held an asset in a community property state and one of them died, it completely eliminated the capital gains tax on that asset. But in the rest of the states, it only eliminated half.
For example, Husband and Wife purchase a property for $100,000. They live in Alaska, which is not a community property state. Years later, when Husband dies, the property is worth $200,000. Wife sells the property. She will have to pay capital gains tax on half of the profit, and if she is in a 20% tax bracket for capital gains, that will result in a $10,000 tax bill. But if the property had been in Arizona, which is a community property state, she wouldn't have had to pay any capital gains tax at all.
So these clever lawyers came up with an idea. Alaska did not want to change its entire property system over to a different type, but the Legislature was willing to pass a bill which allowed people to opt-in to community property. Now, a married couple can have their property declared community property, either by putting it into a community property trust, or by simply signing a community property agreement. And the result is, voila, no capital gains tax if one spouse dies.
Does that mean all married couples in Alaska should convert to community property? Not necessarily. If you don't have assets that are going to be subject to capital gains, this doesn't benefit you at all. Your primary home is typically going to be exempt for the first $500,000 in gain. Tax deferred accounts like IRAs and 401(k)s are not subject to capital gains. And if you're regularly selling your stocks or bonds or mutual funds, you have to pay the capital gains along the way, so you may not have assets in those accounts on which you haven’t already paid the tax.
But people with rental properties or recreational properties that are not their primary home, often have significant gains built up over time. People who own small businesses will often have massive capital gains exposure. And people who buy stocks or other investments and hold them for a long time will also often be subject to a potentially whopping capital gains tax bill if the survivor wants to liquidate. For those people, a community property trust or agreement could be worth a great deal.
I will note that the capital gains tax laws are very complex; I have given only a simplified explanation of some of those laws in this column. I also note that community property trusts and agreements must have certain very specific provisions. This isn't something you want to try to do yourself.
So if you think you may benefit from this, talk to your accountant, financial advisor, or estate planner. They can tell you whether this “one weird trick” could really be one great benefit.
Kenneth Kirk is an Anchorage estate planning attorney. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account. Don’t believe me? As Annie Savoy would say, “You can look it up.”
