How to Avoid Needlessly Exposing a Client’s Assets to Creditors in an Estate Plan or Trust

 

INTRODUCTION

Estate planners often recommend that their clients hold title in community property or in a trust in which the real property interests are held as community property.  They do this primarily to give the client the benefit of a “step-up in basis” for the surviving spouse’s interest in the property. However, community property is liable for the debts of either spouse, but separate property is not. Often the most critical issue for a client who is a prospective judgment debtor is how they hold title to their house. If they hold it in community property, it will be lost; if they hold it as joint tenants, it will, with rare exceptions, be saved. Therefore, unless the benefits of a step up in basis outweigh the risks of exposure, the client will be ill-served by a trust that designates the property as community property.

 

DISCUSSION

1. Holding title in joint tenancy protects the property; holding title in community property does not.

  • Community property is liable for the debts of either spouse. Fam. Code §910.
  • The separate property of a married person is not liable for a debt incurred by the person’s spouse before or during marriage. Fam. Code  §913.
  • At an execution sale of a dwelling held by a judgment debtor as a joint tenant or as a tenant in common, the interest of the judgment debtor and not the dwelling may be sold.  Code Civ. Proc. §704.820.

 

Under this formulation, a creditor cannot levy on or sell a joint tenant’s interest in a dwelling unless it can show that it can pay off all liens and the debtor’s homestead exemption from the sale of the debtor’s interest. Schoenfeld v. Norberg, 11 CA 3d 755 (1970).

 

Example:     Value:                                       $1,200,000

Liens:                                          $400,000]

Homestead Exemption:               [$100,000]

Net Equity on Paper:                    $100,000

Actual Equity:                                         $0

 

2. When is property that is acquired with community property not community property?

  • In re Marriage of Valli, 58 Cal.4th 1396 (2014) overruling In re Summers, 332 F.3d 1240 (9th Cir. 2003) [A spousal purchase during marriage is not subject to the statutory transmutation requirements.]
  • Under Fam. Code §852(a), a transmutation “is not valid unless made in a writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is affected.”  To satisfy the requirement of an “express declaration,” a writing signed by the adversely affected spouse must expressly state that the character or ownership of the property at issue is being changed.  Estate of MacDonald (1990) 51 Cal. 3d 262, 272.

3.  Treatment of joint tenancy interests of debtors in bankruptcy.

  • Bankruptcy trustee can sell co-owner’s interests; with those interests to attach to proceeds.  11 U.S.C. §363 (h).
  • In a bankruptcy sale, the equity is split between the interests, but the entire homestead is applied to the debtor’s interest. Therefore, in Example above, trustee would recover $300,000 less costs of sale.

 

4.  How can the practitioner mitigate the harm of designating interests under a trust as community property?

  • Make the client aware of the risks;
  • Advise the client to be adequately insured;
  • Evaluate the actual benefit of a step up in basis;
  • Arrange for periodic review

 

Example:  In the example above, if the purchase price was $700,000, there would be no immediate need for a step up in basis because in applying the $500,000 capital gains exclusion under 26 U.S.C. §121, the client would not be exposed to capital gain tax.

 

CONCLUSION

The practitioner and client should look before they leap.  The client should make an informed decision as to how they are going to hold title and should evaluate the relative risks and benefits of holding title as community property

or separate property.