Community Property Agreements Explained: A Guide for Couples

Community Property Agreement Defined

A Community Property Agreement is a legally binding contract between two spouses that essentially converts all of their separate property into community property. A Community Property Agreement, however, does not convert real property bought during marriage into community property, nonetheless, it can help in the equitable division of community property in the event of death or divorce. A Community Property Agreement does not negate the need for a Will upon death because at the death of the first spouse, the latter spouse will own all of the other spouse’s Community Property. Nevertheless, the latter spouse should also have a Will that will dispose of the property upon his/her death.
In light of the fact that a Community Property Agreement converts all separate property into community property, it can play an important role in the planning of the disposition of property during one’s life and upon that person’s death. For example, upon the death of the first spouse, the other spouse would inherit one-half of the deceased spouse’s property . For that reason, a Community Property Agreement can be an important component of the estate planning process. When a Community Property Agreement is executed, the testator can then transfer his or her property to a Trust that will provide income to the surviving spouse during that spouse’s lifetime but at the surviving spouse’s death would pass to other beneficiaries thereby saving transfer taxes.
Example 1. Spouse 1 is a millionaire and she is going to be married to Spouse 2. Spouse 1 offers to have a pre-marital agreement drafted that gives all her separate property to Spouse 2 if she dies during their marriage. This is a very generous offer but in California, it would not be recognized unless sworn before a notary public. If the goal, however, is to leave all her property to Spouse 2, then a Community Property Agreement would accomplish this goal. The problem is that in the above example, the pre-marital agreement would have saved community property for the first family and not the second.

States That Allow Community Property Agreements

The states that recognize community property agreements include:

• Alabama
• Alaska
• Arizona
• California
• Idaho
• Louisiana
• Mississippi
• Nevada
• New Mexico
• Texas
• Washington
• Wisconsin

Alabama: Married individuals may modify their property allocations through a community property agreement. Any arrangement modifying property interests of either spouse must be executed before, during or after marriage, and may take effect immediately or at some time in the future. It must be signed and acknowledged by both spouses.
Alaska: All property owned by a married couple is considered community property under Alaska law unless it is separate property owned by either spouse or owned jointly by both spouses.
Arizona: Arizona community property laws follow the same basic guidelines as community property laws in other states. However, there is one unique feature of community property in Arizona: for couples who had a community property agreement in a non-community property state, Arizona will be willing to enforce that agreement – but only if the property was obtained in Arizona.
California: California follows the same basic guidelines as other community property laws. Additionally, California recognizes either community property or community/premarital property agreements.
Idaho: In Idaho, community property laws function generally the same as in every other community property state.
Louisiana: There are two ways to create community property in Louisiana. First, property is community property per se if it is acquired on credit during the marriage. Second, a community property agreement can be executed by a couple with either utroque or ipso facto effects. In the former scenario, upon the signing of the agreement, all property the couple jointly acquires thereafter will become community property regardless of whether the property is purchased legally or with one or both spouses’ credit. In the latter, the community property agreement simply states that the property held either through ownership or credit will be community property.
Mississippi: Community property is either separate or joint, again following the guidelines used in other states.
Nevada: Nevada follows the same basic community property laws as other states.
New Mexico: Similar to Washington, New Mexico recognizes both community property as a whole or via an alternative community property agreement. The difference is that New Mexico does not require community property to be characterized as "jointly-owned" to be considered community property. Any property acquired is automatically community property, unless it is considered separate property.
Texas: Texas community property laws do not require that a couple have both jointly-created and acquired property. Under Texas law, a couple may be considered a community simply by living together. Property in Texas can be classified as either community property or separate property.
Washington: Washington community property laws only allow for community property created by a statutory community property agreement. Alternatively, Washington allows couples to avoid community property laws completely by entering into a different type of prenuptial agreement, a "community property and separate property agreement."

Benefits of a Community Property Agreement

People often enter into Community Property Agreements without considering their estate plan. But a Community Property Agreement, especially one with the right language, can be an important estate planning tool.
For example, most married couples can leave the entire estate to the surviving spouse, including whatever assets are held in joint title, without incurring estate or inheritance tax at the federal level. If there is a community property agreement in place, the first spouse to die makes that possible. Without an agreement, if one spouse dies and completely transfers his or her half interest in community property to the other spouse, this could result in an estate tax, especially if there is real estate outside of the state. A Community Property Agreement may allow the couple to avoid the estate tax when the first spouse dies.
A Community Property Agreement can also reduce the administrative burden on the surviving spouse. Example: two spouses enter into a Community Property Agreement and later one spouse dies, which triggers the passage of the deceased spouse’s half interest in the community property to the surviving spouse. No further transfer between spouses is required. The value of the marital property also receives a step-up in basis at the first spouse’s death, resulting in a reduced tax liability when the community property is sold after the first spouse’s death. Although jointly owned property may receive a step-up in basis at the first spouse’s death under the federal tax law (but not always under state law), property passing by title to the surviving spouse under a Community Property Agreement would typically be entitled to a full step-up in basis under state and federal tax law.
Two spouses may enter into a Community Property Agreement without the need for their signature alone. The Community Property Agreement will be a contract entered into by the signatures of both spouses. This is particularly important for military personnel, because a Community Property Agreement allows married couples to assure that their military spouse property rights are recognized by California law.
Under California law, spouses are presumed to own all property that either spouse acquires during marriage, with the following exceptions:

• Property acquired by gift, devise, or inheritance;
• Property acquired by a spouse in exchange for separate property;
• Income from separate property (except to the extent community property is used to enhance its value);
• Property acquired by a spouse after the date of separation; and
• Earnings and accumulations of a spouse while living separate and apart from the other spouse.

Disadvantages and Risks Involved

While community property agreements offer several advantages, they are not without their potential drawbacks. One primary concern with a community property agreement is that it may not be suitable for couples with children from former relationships. The problem is that a community property agreement provides that all community property passes automatically to the surviving spouse upon death, meaning other heirs may be unintentionally cut out of the estate settlement process. This is one reason why these agreements are not generally recommended for blended families. Without other arrangements, the deceased’s parents, siblings, children and grandchildren may end up with nothing if the surviving spouse inherits everything under a community property agreement. Although a community property agreement can be an effective tool for minimizing estate tax liability, there are also situations in which it may negatively impact tax planning strategies. In some cases, such as when there are sizable assets subject to capital gains tax, retaining title in individual names and using a revocable living trust may provide additional benefits over a community property agreement. A discussion with your attorney and tax advisor will provide guidance in these situations. In some states, a community property agreement may be viewed as a non-probate transfer. In these states, whether the decedent’s interest in the community property is to pass to the surviving spouse outside of probate depends on the nature of the property and how title to the property is held. If the transfer is considered a non-probate transfer under state law, the personal representative may have to re-title the property into the surviving spouse’s name, which can be a lengthy and expensive process.

Creation and Legal Formalities

Drafting a community property agreement requires adherence to strict legal formalities and considerations, including the following:
Formalities

• Both spouses must sign the agreement.
• The agreement must be in writing.
• It must be signed and acknowledged (notarized) by both spouses before a notary public.
• Each spouse must receive a copy of the agreement after it is signed. Failure to provide a copy does not invalidate the agreement. However, each spouse must provide the other with an updated copy after any changes to the agreement.
• The agreement may be enforced in any county, but must be recorded in each county where real property that is subject to the community property agreement is located .

Considerations

• The transfer of any property pursuant to a community property agreement does not result in trigger any tax implications for the transferring spouse or the receiving spouse.
• The agreement must identify the property that each spouse will hold as separate property and the property subject to the agreement, and the agreement must be specific enough that the parties can identify what property is community property and what is separate property.
• The agreement cannot provide for an unequal division of community property if that division would prevent a creditor from collecting the debt that is owed by one of the spouses on community property.

Changing or Cancelling an Agreement

While a community property agreement is designed to simplify matters related to the division of property, its existence does not necessarily have to be permanent. In many cases, couples can modify or terminate a community property agreement at any time by entering into another agreement to that effect.
If a couple wants to modify a community property agreement, the new agreement can address any aspect of community property, including:

• Any real or personal property;
• The manner in which the change will be made; and
• The obligations of each party.

An important note: the new agreement should specifically state that any enforceable provisions of the existing community property agreement will be modified.
There is no elaborate process involved with terminating a community property agreement. At the time the agreement is signed or not later than the 5th day after the date it is signed, each spouse must sign a separate acknowledgment that states in substance: "The undersigned spouse acknowledges that he or she has received a complete copy of this document [the community property agreement] and understands its contents."
You may have decided to file for or have already filed for divorce, and you may want to terminate your community property agreement as part of the divorce. A divorce may be granted without terminating or even "severing" a community property agreement. However, a court may not grant a divorce and also enforce a community property agreement unless it finds that both spouses signed it voluntarily after having an opportunity to consult with independent legal counsel.

Community Property vs. Prenup

While both a prenuptial agreement and a community property agreement are written contracts between spouses that divide property, assets and/or debts in the event of separation or divorce, they each serve a different purpose. A prenuptial agreement is usually reserved for people who are not yet married but want to set aside rights as to the future division of property should the marriage fail in order to avoid litigation, assets being sold pursuant to court order, etc. By entering into a prenuptial agreement, a couple has the opportunity to separately and mutually agree to an alternative method of asset division. For example, if there is a family business that one spouse intends to keep within the family, a prenuptial agreement can be used to limit the rights of the non-owner to a share of the income generated by the business in the event of a divorce. Alternatively, a prenuptial agreement can shield part of a spouse’s assets from the non-owning spouse in the event of a divorce.
In comparison, a community property agreement actually serves to confirm and dissolve a marriage in one document. It makes reference to California’s default assets division laws, identifies the community and separate property of both spouses, designates an alternative arrangement (option two or three above) or divides the assets according to the default rules (option one above). Even if the couple agrees to a division or award that is different from the default rule, a community property agreement is a very clear and enforceable means of setting forth the parties’ intentions regarding the division of their assets in the event of divorce.
In general, a COAP is not appropriate or even allowable if a party to the marriage requires spousal support, if there are children born of the marriage or if there is a unique asset that one party wants to protect.

Examples and Case Studies

Community property agreements are an important tool that can help couples take control of their inheritance process. We’ll examine some real-life examples of how community property agreements can play out in the event of a divorce or death of one party.
Example 1: Bob and Sue Decide to Get Divorced
Bob and Sue had been living together for five years when they decided to get married. Bob was fifty and Sue was thirty-five. As a wedding present, he gave her half of his irrevocable trust. When he died two years later, his parents inherited his money and refused to give any to Sue after his death. Although Sue was married to Bob at the time that he passed and received half of his assets after his death, the remainder remained in the control of the irrevocable trust, which meant that it didn’t matter that Bob was married to Sue when he passed if the beneficiaries were listed as his parents. When he passed away, Sue had no claim to that money nor could she ever benefit from it. Worse, she was still responsible for paying off any of his debts at death. A community property agreement would have addressed this issue.
Example 2: Julie Wants to Leave Her Community Property to Her Children After Death
Julie’s husband had been sick for many years and finally passed away. She was devastated and devastated by the many hospital and other bills he had left with her over the years. In order to avoid paying any bills he left behind (they were living in a community property state in the USA), she decided to give all of her half of the community property to her three children. The problem for Julie is that a community property agreement places half of the property into the control of the spouse. Since they lived community property in a non-reciprocal state, Julie being the surviving spouse was able to give away her half of the community property. But that meant that she gave away the power of survivorship , which meant that when she died, her children would be responsible for those same bills she was trying to avoid paying after his death.
Example 3: Tom and Betty Settle Their Property – and Their Estate
Tom was married to Betty for many years. They created a community property agreement, where they agreed that all of the property owned in their joint names was community property. That meant that when Peter died, Betty automatically took on 100% ownership of the community property by survivorship.
Unfortunately, they also had many other types of property – property they shared and property individually owned. When they first signed the community property agreement, they had much more money than they did were in the years to come. They didn’t lose money on the investments they made; rather, they never updated their estate plan to account for the changing nature of their finances. Because they were older, what came next didn’t matter as much in their eyes because they didn’t expect to live much longer. Instead, they simply signed a durable power of attorney that Jerry would handle all of their finances and made no mention of what they might want to do with their estate.
When they passed away, it meant that Tom and Jerry’s sons made decisions on the many aspects of their estate, such as what to do with their credit card debt and whether to file a lawsuit against a homeless man who caused a car accident by driving under the influence. It certainly didn’t make anyone happy, as it meant that they had significant financial problems they would likely face for many years to come.
The take home message of these examples is that when community property agreements are used, they should be accompanied by a thorough estate plan that accounts for many issues that can arise during the marriage and after the end of the marriage.