Important Change for Married Couples to Avoid Capital Gains Tax

This past summer, the Kentucky Legislature passed a law allowing a trust to be set up as a community property trust. This is important because community property gets a different tax treatment which is beneficial for assets having a low-cost basis. Ultimately, it’s a wonderful planning opportunity to avoid capital gains tax.

Let’s look at an example …

Bob and Sue have a joint investment account. They purchased stock years ago which has grown in value over the years. They don’t want to sell the stock because that will trigger the capital gains tax. If Sue dies, half of the value of the joint account is includable in her estate, and that half of the account will get a step up to her date of death value. Now, when Bob sells the stock, half of the stock is at his original cost, and the other half is at Sue’s date of death value.

If Bob and Sue had put the stock in a community property trust, then at Sue’s death, ALL of the stock steps up to Sue’s date of death value, and Bob can sell the stock with zero capital gains tax.

What assets should go into a community property trust?

Assets that have a low-cost basis, which in most cases are investment assets. (Remember your primary residence has certain exemptions from capital gains taxes, so it may not be necessary for your home.)

What assets would not go into a community property trust?

Retirement assets in a qualified plan (since they do not have capital gains issues). Other unsuitable assets would be those that need creditor protection from a spouse’s potential creditors.

For existing clients with living trusts, the community property trust is a stand-alone trust in addition to your current trusts and it just holds your low-basis assets. After the death of the first spouse, the community property trust splits the assets and the assets are then distributed to the existing living trusts. For clients with will-based plans, their estate plan would now change to living trusts as the foundation plan, with the community property trust as a stand-alone trust for the low-basis assets.

What is the downside of setting up a community property trust?

One is that the law could change, and the step up in basis could be eliminated. This has been proposed in the past and is again being discussed. There is always a chance that laws may change and affect your estate plan. The other risk is that assets in the community property trust are subject to the creditors of BOTH spouses, so you wouldn’t want to put assets in the community property trust if one spouse is likely to be sued.

Who can set up a community property trust?

Only married couples can set up a community property trust. Another requirement is that the trustee must be a Kentucky resident.

If you would like to discuss this law and if it applies to you, call and schedule your consultation at (502) 425-5562.