The tax benefit of community property is that at the first spouse’s death, ALL of it receives a new tax basis. This eliminates all accrued but unrealized capital gains (and losses). Even if the property is only in the name of one spouse, the surviving spouse receives this benefit.
In contrast, jointly owned (but non-community) property is treated as owned 50/50 between spouses who are US citizen or residents. When one spouse dies, only that spouse’s share of the joint property receives a new tax basis, and thus only half of the accrued by unrealized capital gains (or losses) are elimintated.
For example, assume one married couple in Arizona (a community property state) purchases a rental house for $100,000 in 1970 and the house appreciates to $500,000 by the time the first spouse dies. Under the rules in IRC Section 1014, the surviving spouse receives the house with a new tax basis of $500,000 and the accrued but unrealized $400,000 in capital gains is eliminated. The survivor can begin depreciating the house using the new $500,000 basis, which would likely eliminate any tax on rental income from the house. Or, the survivor could sell the house for $500,000 and pay no capital gains tax.
If the same couple resided in and purchased a similar rental house in Colorado (a non-community property state) as joint tenants, the result would be that at the first spouse’s death, the survivor would receive a new basis in the house equal to $250,000 (half of its $500,000 value). The survivor could take depreciation deduction on the $250,000 basis. Or, the survivor could sell the house for $500,000 and pay capital gains on $250,000 (assuming a federal rate of 23.8% that is $59,500 and the historic basis was fully depreciated).
Is there a way for the Colorado couple to save on the $59,500 in capital gain? Rev. Rul. 79-124 suggests there may be (at least in part) if the rental house is contributed to a partnership for federal tax purposes and the partnership interests are community property.
In that Revenue Ruling the IRS was asked whether the partnership interest of A, who died, which was solely in A’s name and was community property, is permitted a full 743(b) adjustment for B, A’s surviving spouse who held a community property interest in the partnership (though B was not named as a partner for state law purposes).
Under the rules of IRC Sections 743 and 754, when a partner dies and the partnerhship makes a timely 754 election, the partnership may adjust the basis of the partnership assets equal to the deceased partner’s basis in the partnership interests and proportionate to the partners share of the partnership assets. The adjustment only applies to those receiving the deceased partner’s interest in the partnership. Under IRC Section 742 (and its regulations) a surviving spouse with a community property interest in a partnership interest receives the full basis adjustment under IRC Section 1014 (similar to the Arizona rental house in the example above).
In Rev. Rul. 79-124, the IRS concluded that B was entitled to a full adjustment to the basis of the partnership assets equal to the community property value (not just B’s 50% interest in the community property) under IRC Section 743 and 754.
Can non-community property that is immovable (like real estate) become community property to get a full basis adjustment at death? Rev. Rul. 79-124 suggests that converting non-community property to a community property partnership interest (with a 754 election at a spouse’s death) might do the trick.
For example, if spouses own a 50% partnership interest in a partnership that owns the same rental property in the examples above and one spouse dies, a timely 754 election would result in the following: (1) the surviving spouse would adjust the basis in the 50% partnership interest to $250,000 (assuming no valuation discounts) and (2) under IRC Sections 743 and 754 the partnership would adjust the surviving spouse’s share of the basis of the rental property to $250,000. If the partnership then sold the house for $500,000, the surviving spouse would pay no capital gains because the basis of the property in relation to the surviving spouse is $250,000 and the amount of the gain allocated to the surviving spouse from the sale is also $250,000.
How can this help the couple in Colorado in the example above? If they move to Arizona and take up Arizona residency, Rev. Rul. 79-124 suggests they could contribute the Colorado rental property to an Arizona LLC taxed as a partnership, gift a small interest to their children in order for the LLC to be a partnership for federal tax purposes, and their LLC interest would be community property under Arizona law. When the first spouse dies, the property the deceased spouse would own is the LLC interest and not the house (because under Arizona law the assets of the LLC are not the assets of the members). If the LLC makes a timely 754 election (assuming the LLC is respected as a partnership for federal tax purposes), a basis adjustment could be made for the survivor’s interest in the rental property equal to the full community property value. So, if the couple had gifted 10% of the LLC interests to children, retaining 90%, and assuming there are no other estate tax inclusion issues as to the 10%, their 90% community property interest would have a basis adjustment to $450,000, assuming no valuation discounts (i.e. 90% of $500,000), and the 743 adjustment to the rental house’s basis for the surviving spouse would be to $450,000. If the LLC then sold the house for $500,000, the surviving spouse would have no capital gains (because 90% of the gains of $500,000 allocated to the survivor would equal the survivor’s basis in the house) and the children would share a capital gain of $50,000 (i.e. $50,000 in gain allocated to them minus a $0 basis assuming the historic basis was fully depreciated). It is likely the children’s federal capital gains tax rate, however, would be less than 23.8% if they do not have adjusted gross income of more than $441,450 (for single filers in 2020) or $496,600 (for married filing jointly filers in 2020).
Thus, Rev. Rul. 79-124 suggests that there may be ways to get community property basis adjustment benefits even in the case of property that is immovable non-community property. Every situation is unique, so no example above applies broadly. Analyze each circumstance based on its specific facts.