Community vs. Separate Property - Why It Matters

[David Disraeli]

The concepts and challenges of community property are not well understood and result in confusion and planning errors. Nine states are known as community property states and the others are not. I am only familiar with how it works in Texas so these concepts may not all apply in your state. If you live in a community property state and are married, you own ½ of the assets that were accumulated during your marriage. This may only seem important if you divorce, but there are many reasons this the topic may become relevant. Separate property includes property you owned before you were married, property you inherited, income and gains from separate property and damage awards from a lawsuit. However, separate property may easily become community property due to the way it is held and managed. Generally a judge will divide a community estate in half, although most divorcees would argue that they wound up with far less than half. One fellow said, “we split everything down the middle, even the house – she got the inside and I got the outside”.

There are many reasons to understand how community property and separate property work, divorce and death are just two reasons. It is also important to understand how separate property loses its “character” as separate property and becomes community property. Separate property must always be kept separate to maintain its character. Once there is any comingling of separate and community property, the property becomes ALL community property. Here is one example. John is married and inherits $100,000 house from his mother. He sells the home and temporarily parks the money in his joint checking account. Later he buys another property and titles it in his name only. Because the money was community property for a short time, experts will tell you the house he bought is now community property. Of course the final answer would come from a court but this happens frequently and can easily be avoided. Another example would be if John never sold the inherited house but used joint funds to make improvements. Now the house is “comingled” with community property and separate property. Most people assume that the money used to make improvements is the only portion that is community property. Well - property is either community or separate, not both. Think of it as putting a small amount of poison in a gallon of ice tea. The whole gallon is undrinkable.

What does this matter if you don’t plan on getting a divorce? First, no one plans on getting divorced, yet many do. Second, if you own a business with a partner and die, your spouse is now in business with your partner and he or she may not be the best architect, electrician, dentist, or otherwise know anything about the business. If the business were owned and kept as separate property, it would not pose a problem. The deceased person’s share of the business can be passed to the surviving business partner. Community property is a concept where you own half of the community estate, but not a specific half. You own an undivided interest. In the case discussed, your spouse would have to sell their interest in the business to the surviving partner, but at what price? And where would the surviving partner get the cash? This same concept extends to other assets like real estate. How can you transfer via your will a rent house to your son from a previous marriage when you only own a portion of it and not a specific portion? Your spouse would have to agree to this in advance, and honor the agreement when you are long gone. You can see how community property can get tricky in a hurry via any number of situations. The only way you can be certain that a particular asset is left to a non-spouse is if you own it as separate property.

Partitioning Your Marital Estate Right Now

There is a method of converting some portion of community property into separate property. This is called partitioning. Spouses may agree to separate their community property, or a portion thereof, but written agreement. This is similar to a post-nuptial agreement. These agreements must be entered into carefully and with the help of an attorney who does them regularly. Why would anyone do it? Partitioning may be done by couples who wish to remove stress and uncertainty about their future together. It may sound like one step towards divorce but it may also remove stress over money by saying “you do your thing and I will do mine”. It may be done where they are multiple marriages, children from prior relationships or other reasons. It may also be a great asset protection tool for those in high-risk professions like doctors. Creditors may attach all of the community estate even if the judgment is against only one party. By moving property to the spouse of a high-risk professional, it makes certain assets off limits. This requires complete trust between spouses. One last thought: If separate property continues to maintain its character as such, all the income or growth of such property is also separate – as long as you keep it that way.