Understanding the New Florida Community Property Trust, Part I.

• Author: Percopo, Joseph M.

The Florida Community Property Trust Act, (1) which is effective for such trusts created on or after July 1, 2021, provides many benefits to married couples, the most significant of which is the potential income tax treatment of trust assets at the first spouse's passing.

Because Florida is a common law property state, Floridians may not have a good understanding of community property. In Florida, like in most other common law property states, how an asset is titled generally dictates who owns the asset and who has the ability to convey it during life or at death. Before the act, the primary forms of joint ownership in Florida consisted of tenants in common, joint tenants with rights of survivorship (JTWROS), life estates, and a form of ownership only available to married couples called tenants by the entirety (TBE). (2)

In contrast, in a community property state, of which there are only nine, (3) assets acquired during marriage are generally considered to be owned one-half by each spouse regardless of how the assets were acquired or titled. (4) Therefore, when a spouse in a community property state dies owning such property, he or she may devise only his or her one-half interest in the asset.

The act allows spouses to opt into community property treatment of any assets held in a Florida Community Property Trust (FLCPT). To explain the significant federal income tax benefits of a FLCPT, Part I of this article begins with a basic explanation of applicable tax law assisted by examples and illustrations of the same. Next, Part I of this article summarizes the act and the requirements to create a FLCPT.

The rest of Part I and all of Part II of this article is dedicated to important considerations before using a FLCPT, including tax basis, the death of a spouse, homestead, creditors, business entities, gifts to spouse, nuptial agreements, and enforceability issues.

Tax Law Basics

The Internal Revenue Code (I.R.C.) (5) imposes an income tax (6) on taxable income "from whatever source derived." (7) This broad definition captures, among a long list of items, gain from the sale of an asset. Gain is the difference between the amount received and the basis of the asset being sold. (8) Generally, a taxpayer's basis in an asset is equal to the amount paid for the asset. (9)

* Example 1--If a taxpayer pays $300 for a share of stock, the basis in that stock will be $300. If the share is then sold for $700, the taxpayer will recognize gain of $400 ($700 sales price less the $300 cost).

Whenever an asset is acquired, the buyer has a basis in that asset. When purchased, the basis is generally equal to the purchase price. Assets may also be acquired by gift or inheritance. When an asset is acquired by gift, the recipient (donee) takes a basis in the asset equal to the basis the gift giver (donor) had in the asset immediately before the gift. (10) When an asset is acquired by inheritance upon the donor's death, the donee takes a basis equal to the fair market value (FMV) of the asset determined on the date of the donor's death. (11) If the FMV basis adjustment is upward due to the asset's appreciation, the basis adjustment commonly is referred to as a "step-up" in basis. (12)

* Example 2--Donor owns a limited liability company taxed as an S Corporation (13) (LLC) worth $150,000 that she had purchased for $100,000. If she sells her LLC interest, she will have to recognize gain of $50,000 ($150,000 FMV-$100,000 basis). If she gifts the LLC, the donee will have a carryover basis of $100,000 (the same basis as the donor). Thereafter, if donee sells the LLC for $150,000, Donee will be taxed on $50,000 of gain.

* Example 3--Same donor and LLC as in Example 2. Donor dies and leaves the LLC to donee in his or her will. Donee will have a stepped-up basis in the LLC of $150,000. (14) Thereafter, if Donee then sells the LLC for $150,000, he or she would have no gain ($150,000 FMV-$150,000 basis = $0) and owe no income tax on the sale.

The basis adjustment at death is also impacted by the manner in which the property is owned. If the donor owns all of an asset and dies with it, then all of that asset gets a FMV basis adjustment in the hands of the donee. Nonetheless, when an asset is owned as JTWROS, TBE, or community property, the basis determination gets trickier. For unmarried taxpayers who own property as JTWROS, the asset's basis adjustment will depend on the extent of its inclusion in the first owner/decedent's gross estate at death. (15) "The entire value of jointly held property is included in a decedent's gross estate unless the executor submits facts sufficient to show that property was not acquired entirely with consideration furnished by the decedent, or was acquired by the decedent and the other joint owner or owners by gift, bequest, devise, or inheritance." (16)

FIGURE 1 COMMUNITY PROPERTY INCOME TAX ILLUSTRATION Assets Gain from Acquisition Fair Market Sale During cost (Basis) Value (FMV) Life Stock $300,000 $700,000 $400,000 Real Property (*) $500,000 $1,200,000 $700,000 Total: $800,000 $1,900,000 $1,100,000 Long Term Capital Gains Tax (LTCG) (**) 20% $220,000 (Tax Owed) Assets Owned: 100% Husband 100% Wife ("H") ("W") H's Death Gross Estate Inclusion (100% inclusion) (0% inclusion) Stock $700,000 $0 Real Property $1,200,000 $0 W's New Asset Basis H's FMV Stock $700,000 $0 W's Stock Basis $0 $300,000 Total: $700,000 $300,000 H's FMV Real Property $1,200,000 $0 W's Real Property Basis $0 $500,000 Total: $1,200,000 $500,000 W's Stock Basis $700,000 $300,000 W's Real Property Basis $1,200,000 $500,000 Total: $1,900,000 $800,000 W's Sale as Assets Total FMV $1,900,000 $1,900,000 Total Basis $1,900,000 $800,000 Gain: $0 $1,100,000 LTCG 20% tax $0 $220,000 W's Tax Savings $220,000 $0 Assets Owned: H&W Tenants H&W bythe Community Entirety Property H's Death Gross Estate Inclusion (50% inclusion) (100% inclusion) Stock $350,000 $700,000 Real Property $600,000 $1,200,000 W's New Asset Basis H's FMV Stock $350,000 $700,000 W's Stock Basis $150,000 $0 Total: $500,000 $700,000 H's FMV Real Property $600,000 $1,200,000 W's Real Property Basis $250,000 $0 Total: $850,000 $1,200,000 W's Stock Basis $500,000 $700,000 W's Real Property Basis $850,000 $1,200,000 Total: $1,350,000 $1,900,000 W's Sale as Assets Total FMV $1,900,000 $1,900,000 Total Basis $1,350,000 $1,900,000 Gain: $550,000 $0 LTCG 20% tax $110,000 $0 W's Tax Savings $110,000 $220,000 (*) Assumes no valuation discounts and no eligibility for primary residence sale gain exclusion under I.R.C. [section]121 (**) "Calculated without taking into account I.R.C. [section]1411 (3.8% net investment income tax) * Example 4--Unmarried A and B own real property worth $1.2 million as JTWROS. A contributed $400,000 and B contributed $100,000 to acquire the property, resulting in A owning a 4/5 interest and B owning a 1/5 interest. If A dies first, his estate will include $960,000 as his FMV of the real property out of the total $1.2 million FMV, or 4/5 of the total). Thereafter, A's 4/5 interest will have an adjusted basis of $960,000. Since the investment was owned as JTWROS, B will now own all of the real property. Her new adjusted basis will be $1,060,000 ($960,000 basis step-up attributable to deceased A's interest added to B's original $100,000 basis). After A's death, if B sold the real property for $1.2 million, she would recognize only $140,000 in gain ($1.2 million sale price-$1,060,000 basis).

In the case of married taxpayers who own property as JTWROS or TBE, special inclusion rules apply whereby only half of the asset is included in the deceased spouse's estate regardless of the individual amounts invested by either spouse in acquiring the asset. (17) Therefore, upon the death of the first spouse, the surviving spouse will receive a basis adjustment on half of the FMV of the property (excluding any valuation discounts). (18)

* Example 5--Married H acquired stock with an initial investment from his separate assets of $300,000. He took ownership of the stock with his wife, W, as TBE, effectively gifting her one-half of the stock and resulting in each of them having a $150,000 basis. (19) Then H dies when the stock is worth $700,000. Half of the value of the stock, or $350,000, is included in H's estate. Since the stock was owned as TBE, W will now own all of it. Her new adjusted basis will be $500,000 ($350,000 basis step-up from H's interest added to W's carryover basis of $150,000). After H's death, if W sold the investment for $700,000, she would recognize only $200,000 of gain ($700,000 sale price-$500,000 basis).

* Example 6--Same married taxpayers as in Example 5. H and W sell the stock before H's death. They will recognize gain of $400,000 ($700,000 FMV-$300,000 combined basis of H and W).

In contrast, when a married couple acquires an asset as community property, provided at least half of its FMV is included in the deceased spouse's estate, (20) the surviving spouse generally will receive a basis adjustment of the entire FMV of the asset. (21)

* Example 7--Married H and W buy publicly traded stock as community property, each paying $300,000. H then dies when the stock is worth $700,000. Half of the stock's value of $350,000 is included in H's estate. Since the stock was owned jointly as community property, W will now own all of the...