Characterization of Community Property and Seperate Property

In estate planning, as in all parts of life, marriage is considered a partnership. That means, with limited exceptions, married couples must coordinate the disposition of their assets and estates.

To that end, one of the first questions that your estate planning attorney should ask is whether either of you or your spouse intends to hold any assets as your separate property. Many couples avoid the need for this step by agreeing to characterize all property that they currently own as community property, owned equally by both spouses.

But, in some cases, one spouse may want to maintain individual control over particular property. For example, a husband with children from a previous marriage may want to maintain the separate property nature of an old brokerage account so that he can leave the account to those children.

When either or both spouses wish to maintain separate property, it is critical to undertake an examination of the couple’s assets and determine which assets can be properly characterized as separate property.

In community property states, like California, “community property” generally includes all property and earnings acquired by either spouse during the marriage except property acquired in a gratuitous transfer, like a gift or inheritance, or income received from a separate property source. “Separate property” in contrast, includes property acquired before marriage or by gift or inheritance, and any income from a separate property source, like rent from a building that a spouse owned before marriage.

Let’s take a look at some of the most common community property and separate property characterization issues.

Property is presumed to be community property if it is acquired during marriage.

Any property acquired during a marriage is presumed to be community property. A spouse attempting to assert that property acquired during a marriage is separate property bears the burden of proof.

Meeting that burden can be especially difficult if the claimed separate property has been commingled with community property. In that case, courts will presume that the couple intended for the commingled assets to be considered community property.

For example, if a spouse owns a rental property as separate property but contributes the rent received from the rental property into a joint checking account owned and used by both spouses, the income will likely be considered commingled community property. Although the rental property itself is separate property, by commingling the rental income with the second spouse’s assets, the first spouse has converted the income from separate property into community property. This commingling of income does not change the character of the rental property itself but does mean that the income deposited in the joint account is community property, owned and controlled by both spouses equally instead of just the first spouse. (But note in Idaho, Louisiana, Texas, and Wisconsin, rents or profits received from separate property are considered community property, just like income from a job).  

The community property estate can be reimbursed for contributions made to separate property assets, like a home.

In some cases, a married couple may use both separate and community property assets to acquire property. This situation arises frequently when one spouse already owns a home before getting married and subsequently uses community property funds to pay down the mortgage or make improvements. In that case, if the home is sold, then the couple’s community property estate is entitled to reimbursement for the amounts it contributed.

In California, if community property funds are used to pay down the principal of a mortgage, then the community property estate is entitled to a pro-rata share in the appreciation of the property. In other words, the equity in the home will be treated as separate property to the extent that the first spouse’s separate property paid for the principal purchase price and community property to the extent that community property paid for the principal purchase price.

But the situation is different with respect to improvements to the home. In that case, unless the improvement can be proven to directly increase the value of the property, the community property estate is only entitled to be reimbursed for out-of-pocket expenses from any proceeds from the sale of the property.

Changes in the value of a separate property business are divided between the separate property and community property estates.

As discussed above, in California and several other states, income from a separate property asset is considered to be separate property, unless it is donated to or commingled with the community estate. But, different considerations apply to the increase in the value of the business itself.

If the value of the business increased because of the efforts of the spouse, then their separate property estate is entitled to a reasonable rate of return on the amount of the increase, but the rest is considered community property. This rule acknowledges that it was likely because of the benefits created by the marriage that the spouse was able to expend the effort to build the business and the community estate should, therefore, retain the upside benefit of the growth of the business.

If the value of the business increased due to the inherent nature of the business, as opposed to the spouse’s specific efforts, then the community estate is only entitled to a portion of the change in value up to the value of the services provided by the spouse to the business (but only to the extent not already distributed to the community estate in the form of salary). This rule acknowledges that the general market is responsible for the increase in value, not the advantage of being married, and therefore awards the upside benefit of the growth of the business to the first spouse as their separate property.

Damages awarded from personal injury cases are considered community property.

In California, the right to recover personal injury damages for injuries suffered during a marriage are considered community property, regardless of whether the damages awarded are for lost wages, medical expenses, or pain and suffering. Although in divorce proceedings, the recovery is usually assigned to the injured spouse, recoveries from personal injury lawsuits can be tricky to navigate in estate planning. Spouses looking to leave proceeds of personal injury lawsuits to specific heirs should work with an estate planning attorney to ensure that their wishes are met and cannot be overridden by their spouse after they pass away.

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Contact the Law Office of Ravi Patel if you need help preparing your estate plan or working through community and separate property characterization issues.