Disadvantages of the Florida Community Property Trust
Although community property trusts are a powerful way to potentially pay less in taxes, they also come with some disadvantages. The trusts are still a great estate planning tool, but like all things in life, you have to weigh the pros and cons before making the decision right for you. Using a community property trust has the following disadvantages:
1. Lack of Protection From Creditors
If your marital property is in a community property trust, then it by definition cannot be owned as tenants by the entirety. This is a disadvantage because tenancy by the entirety comes with a big asset protection benefit. If a creditor of one spouse attempts to come after assets held as tenants by the entirety, they will find that the assets are out of reach and safely in the hands of the spouses. Tenancy by the entirety protects assets from all creditors of either spouse individually. Unless both spouses owe money on the same debt (or both signed consenting to the debt), the tenancy by the entirety asset cannot be reached by the creditor. But you give that protection up by putting the asset in a community property trust.
Some people see this issue and think that the clear answer then is to forget about community property and instead create a trust that states all assets are held as tenants by the entirety. That way you keep all the asset protection benefits. However, this comes with its own downsides. First, tenancy by the entirety gets only half the step up in basis that community property gets, meaning the tax savings tend to be much better on community property. Second, Florida law is unclear about whether trust assets can be held as tenants by the entirety. To get the best of both worlds, you might only put assets with large amounts of appreciation in a community property trust and leave some other assets as tenants by the entirety with a pay on death designation into the trust. But whether this is a good idea for you depends on your need for creditor protection compared to the potential tax savings. Simply put, if asset protection is a concern for you, you should speak with an estate planning lawyer to determine what options work best for you.
2. Assets Become Marital Property
If you put your assets into a community property trust and later get divorced, you will find that all assets in the trust are marital property. And if an asset is marital property, then it could be lost or divided in the event of a divorce. Compare this to non-marital property which belongs only to a single spouse and is not part of the asset splitting in a divorce. Thus, assets that were obtained from sources unconnected to a marriage, such as an inheritance, that have been kept separate from marital property will lose their nonmarital status the moment they are moved into the community property trust. In other words, a community property trust is not ideal for spouses that have significant nonmarital property and are worried about a potential future divorce.
3. Uncertain Tax Consequences
As mentioned above, we do not know for sure whether the community property trusts will actually result in the full step up in basis. However, we have thoroughly researched this matter, and our opinion is that the trusts will get the tax break and that the IRS is unlikely to even challenge the law. We do not have a crystal ball to peer into the future, but we can tell you that the IRS itself has conceded on multiple occasions that similar community property arrangements result in legitimate tax savings.
4. Potential for a Step-Down in Basis
The flip side of a step-up in tax basis is the step-down in basis. A step-down in basis occurs when an asset decreases in value instead of increasing. For example, if you purchased $50,000 of stock in Widgets Enterprises, LLC and the stock was worth only $30,000 when you died, then the new tax basis in the stock would be $30,000. In other words, if your capital assets lose value, the taxable loss is erased (just like the taxable gain would be erased). Thus, the community property trust should only be used for assets that you anticipate will not decrease in value before you pass away.
Final Thoughts
Like most estate planning tools, the community property trust has disadvantages. However, I still recommend the trust to many clients because of the incredible tax savings they very likely will bring about. The trusts are still worth creating for many people with unrealized taxable gain. The key is to find a good estate planning attorney who will help you weight the advantages and disadvantages to make the right decision for you.