Step-up-in-basis in a Community Property State

Many married couples spend years building wealth through real estate, businesses, investment accounts, and retirement planning. Yet one of the most valuable tax benefits available to married couples is often overlooked entirely: the step up in basis available for community property.

For couples living in community property states such as Arizona, California, New Mexico and Texas to name a few, proper ownership and trust planning can potentially save hundreds of thousands, or even millions, of dollars in capital gains taxes when the first spouse passes away.

The key is understanding how community property interacts with a revocable living trust.

A “step up in basis” refers to the adjustment of an asset’s tax basis to its fair market value at death. Basis is generally what you paid for an asset, adjusted for improvements, depreciation, and other factors. When an asset is sold, capital gains tax is calculated based on the difference between the sale price and the basis.

For example, assume a married couple purchased a rental property years ago for $500,000. Over time, the property appreciated and is now worth $2,000,000.

In many states, if one spouse dies, only the deceased spouse’s half of the property receives a new stepped-up basis. The surviving spouse’s half retains its original basis. This creates a partially taxable gain if the property is later sold.

However, in a community property state, the rules are significantly more favorable.

If the property is properly characterized as community property, then upon the death of the first spouse, both halves of the property receive a full adjustment in basis to current fair market value.

In this example:

• Original purchase price: $500,000
• Value at first spouse’s death: $2,000,000
• New basis after death: $2,000,000

If the surviving spouse later sells the property for approximately that amount, there may be little or no capital gains tax due.

This is one of the most powerful income tax benefits available under community property law.

Many clients assume that simply placing assets into a joint revocable living trust automatically guarantees this result. That is not always true.

The revocable living trust itself is not what creates the tax benefit. The critical issue is whether the assets retain their community property character under state law and under the trust agreement.

A properly drafted joint revocable trust in a community property state should clearly identify community assets as community property and preserve that characterization throughout the estate plan.

Problems can arise when:

• Assets are titled incorrectly
• Separate property and community property are mixed together without clarification
• The trust language is vague
• Property is titled as joint tenancy instead of community property
• LLC interests or brokerage accounts are inconsistent with the trust provisions
• The trust unnecessarily divides assets into separate survivor’s trusts too early

These issues may create ambiguity that can jeopardize the full basis adjustment.

In Arizona, many married couples intentionally title assets as “community property with right of survivorship.” This can combine several benefits simultaneously:

• Probate avoidance
• Automatic transfer to the surviving spouse
• Preservation of community property status
• Full double step up in basis at the first death

This planning can be especially valuable for:

• Appreciated real estate
• Rental properties with heavy depreciation
• Family businesses
• LLC interests
• Investment portfolios
• Private equity holdings
• Cryptocurrency and digital assets

For high net worth families, there is often a balancing act between estate tax planning and basis planning.

Some irrevocable trust strategies are designed to remove assets from the taxable estate in order to reduce future estate taxes. While that can be beneficial in certain cases, it may also eliminate the opportunity for a future basis adjustment at death.

As a result, sophisticated planning often involves deciding which assets should remain includable in the estate to preserve a step up in basis, and which assets should be shifted outside the estate for transfer tax purposes.

In today’s environment, many families are far more exposed to capital gains tax than federal estate tax. For those clients, preserving basis adjustment may be more economically important than aggressive estate tax minimization.

This is why proper coordination between trust drafting, tax planning, and asset titling is essential. A well-designed revocable trust is not simply about avoiding probate. When structured properly, it can preserve substantial tax advantages for the surviving spouse and the next generation.

Lodmell & Lodmell, PC is one of the nations leading Asset Protection Law Firms and the creators of The Bridge Trust®.  L&L serves clients nationwide and may be reached at [e-mail] or 602-230-2014.