Volume 8, Issue 4
The Wealth Counselor
Income Tax Planning with Alaska Community Property Trusts
The Internal Revenue Code (“IRC”) provides substantial income and estate tax benefits to the married residents of the nine “community property” states. A tenth state – Alaska – allows married couples to opt in to the community property regime and reap these benefits. In addition, Alaska offers the married residents of the other 40 states a way to reap these benefits by using its community property law.
This simple income and capital gains tax planning trust strategy is one that advisor teams in those 40 states can use to distinguish themselves from other advisors and bring real value to their clients. While this strategy has been underutilized in the 15 years since the Alaska Community Property Act was passed, the recent changes in income and capital gains tax rates have made it especially valuable.
In this edition of The Wealth Counselor, we will review the 2013 changes to the federal income and capital gains tax laws, explain community property law basics and tax benefits, explain how an Alaska Community Property Trust works, and identify some appropriate applications.
The Problem of Capital Gains Tax
Current Capital Gains Tax Rates
Adjusted Gross Income 2012 Rate 2013 Rate
Add State Capital Gains Tax
Add Recapture of Depreciation
Example: John and his wife Mary own an apartment building in Illinois that they purchased for $1 million in 1978. It is now worth $10 million. If they sell it, they will have a gain of $9 million. The property has a depreciated basis of zero, so they will also have $1 million of depreciation recapture. They have more than $450,000 in other income. Here’s what will happen if they sell their apartment building and why they may not want to:
20% Federal capital gains tax (on $9 million) $1,800,000
The Hold Until Death Strategy
Planning Tip: Many people are tempted to hold onto appreciated property until they die so their children will get the step up in basis.
Example Variation #1: Assume that John is the sole owner of the apartment building and leaves it to Mary upon his death in 2013. Under IRC Section 1014, Mary receives a “step up” in basis to $10 million, the fair market value of the property. If Mary then sells, there is no tax on the gain or depreciation recapture – a tax savings of more than $2.9 million.
Example Variation #2: Assume John and Mary own the building jointly and John dies. IRC Section 1014 provides Mary a “step up” in basis on John’s half of the property to $5 million. Added to Mary’s basis on the other half, that results in a new basis for Mary of $5 million. Upon sale by Mary at $10 million, capital gains tax and recapture is still over $1.4 million.
Each state’s community property law is slightly different from those of the other community property states, but, in general, a community property regime is similar to a partnership. Each spouse has a one-half undivided interest in the community property, so the property is held as a whole and cannot be divided into his/her shares.
Death Basis Adjustment of Community Property
Here’s how that works:
Example Variation #3: Assume John and Mary own the building as community property. When John dies, the property will receive a full “step up” in basis for Mary to fair market value of $10 million. If she sells it at $10 million, there will be no capital gains tax. Community property treatment thus saves about $1.4 million in capital gains tax. If Mary doesn’t sell, she can depreciate the property’s improvements at its new basis of $10 million minus the value of the land.
Planning Tip: The result is that appreciated real estate, marketable stocks or family businesses held as community property can avoid all capital gains tax upon sale after the death of the first spouse.
The Alaska Community Property Trust
An Alaska Community Property Trust thus allows John and Mary to take advantage of Alaska’s community property laws and have their Chicago apartment building characterized as community property.
How It Works
An Alaska Community Property Trust is a joint revocable living trust. However, the Alaska Community Property Act imposes certain conditions on it. It must have an Alaska trustee, which can be a bank or trust company that exercises trust powers in Alaska or an individual whose true and permanent home is in Alaska. Also, the Alaska trustee must have at least certain specified powers or responsibilities regarding the trust, which do not have to be exclusive. Thus the trustmakers may serve as co-trustees to manage the property and assets held in the trust, and to take the income and, upon the death of the first spouse, have the trust assets “pour over” into the spouses’ home state revocable living trusts.
Planning Tip: Assets transferred to the Alaska Community Property Trust will be titled in a way similar to: “John and Mary Smith, Trustees, and ABC Trust Company, Administrative Trustee, of the John and Mary Smith Alaska Community Property Trust dated ____________.”
Planning Tip: Asset accounts can continue to be managed by the current advisor. An additional statement will need to be provided to the Alaska trustee.
Planning Tip: An Alaska bank or trust company’s annual trustee fee for the minimum services and responsibilities required by the law is likely to be around $2500 per year. Fees are not fixed by law and so a trustee may charge less, especially if the client has another relationship with the bank or trust company. The client can determine if the benefits exceed the costs by comparing the trust creation and maintenance fees over the oldest client’s life expectancy to the amount of capital gains tax that having the trust will avoid.
What to Look for When Evaluating Clients for this Strategy
Couples Less Likely to Benefit from Using this Strategy
Planning Tip: Advisors in community property states should also be aware of this strategy for their clients who have relocated to a non-community property state.
Alaska Community Property Trusts Benefit Clients and Advisors
Educating the Client and Advisors
Here are some suggestions to help you get started:
Planning Tip: The Alaska Community Property Trust works well with assets that have been placed in a Limited Liability Company or Family Limited Partnership. (The Alaska Community Property Trust will simply hold a membership interest in the LLC or limited partner interest in the FLP.) It also can work well with buy/sell agreements for family businesses.
 The Alaska Community Property Trust is a completely different vehicle than the Alaska Domestic Asset Protection Trust.
Law Offices of J.R. Hastings • 1003 Third Street, San Rafael, California 94901 • 415-450-6692