Estate Planning Red Flag

In community property states, it is common for couples to place marital assets in a joint revocable trust rather than separate trusts. Doing so preserves the assets’ community property status so that, when one spouse dies, the surviving spouse receives a “double step-up” in basis. In other words, the bases of all of the assets are stepped up to their fair market value on the date of the first spouse’s death, minimizing the surviving spouse’s future capital gains tax liability.

In non-community-property states, only the deceased spouse’s share of jointly held assets receives a basis step-up, so a joint revocable trust does not provide the same tax advantage. Nevertheless, these trusts are also popular in these states.

In both types of states, joint trusts offer many of the same benefits as separate trusts — including probate avoidance, guardianship avoidance, privacy, and asset management in the event of a spouse’s incapacity. Plus, they offer administrative convenience and the psychological benefit of holding assets jointly.

But they do not provide the same level of creditor protection as separate trusts. If you live in a community property state, you should weigh the asset protection benefits offered by maintaining each spouse’s separate property in a separate trust against a joint trust’s tax benefits.

If you live in a non-community-property state and the value of your and your spouse’s combined estates exceeds the estate tax exemption ($5.12 million for 2012, but scheduled to drop to $1 million next year), you will also need to consider the potential tax pitfalls of a joint trust that can result in unanticipated gift or estate taxes. It may be possible to avoid these pitfalls by drafting the trust document carefully and keeping accurate records of each spouse’s contributions. But even with careful planning, there is a risk that the IRS will challenge your tax treatment of the trust. So unless your potential gift and estate tax exposure is minimal, separate trusts are generally preferable.

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