If you are married and live in a community property state, you and your spouse may not think about whether certain assets are community or separate property. The former is generally all property acquired during the marriage, and the latter consists of property owned by each spouse before they wed. Separate property also includes assets inherited by one spouse or gifted to the individual. Say one spouse inherited a house from their parents, and rent out the dwelling. The rent received by the inheriting spouse is considered separate property.
Perhaps the marital home is actually separate property, as one spouse owned it prior to the marriage. Even though the spouses may share financial responsibility for the house, such as paying the mortgage and taxes together, or other expenses such as insurance and repairs, in reality the home belongs to just one of them. No matter how much the non-owning spouse may contribute to the property’s upkeep, it’s not a marital asset. For fairness’ sake, it may make sense to change the property from separate to community, via a process known as transmutation.
What is Transmutation?
Under California’s Family Code section 850, transmutation is “an interspousal transaction by which the character of personal or real property is changed in one of three ways: from separate to community, from community to separate, and from the separate property of one spouse to the separate property of the other spouse.”
Keep in mind that every community property state has regulations regarding property transmutation. For example, in California, a written agreement between spouses can change property status. Such a written agreement doesn’t have to state the term “transmutation,” a term which few outside of the legal community is familiar. Any agreement must make it clear that the property ownership status is changing. Both spouses must sign the agreement transmuting the real estate.
Transmutation by Mistake
On the flip side, a couple can mistakenly bring about a transmutation. Perhaps the family home is community property and the owners decide they want to refinance it. The bad news is that one spouse has a low credit score, making refinancing either impossible or very expensive. In this situation, the spouse with poor credit can use a quitclaim deed, transferring their share of the property to the other spouse. Now they refinance the property at a reasonable interest rate, and once the refinancing is complete, transfer the property back to community property.
Let’s say the couple never get around to transferring the property back to both of them. A few years down the road, one spouse decides the marriage is over and files for divorce. Both are probably shocked to discover – and shocked is probably not the appropriate word for the non-owning spouse – that only one of them owns the property as far as the law is concerned.
This is where divorce lawyers may have a field day. When a property is transmuted and it ends up that one spouse is seriously advantaged over the other spouse, invalidating the transaction is a possibility. That means it is up to the spouse who now legally owns the property and their attorney to prove no undue influence occurred. They must prove that the transmutation was voluntary on the part of the other spouse and that both spouses were fully informed about the transmutation and its effects. If the spouse wants to keep the transmuted property in the divorce, it is critical to prove that the other spouse was fully aware of the consequences of the transmutation when it was made.
Creating an Estate Plan
Every couple should have an estate plan in place. Those couples living in community property states must pay special attention to how their property is characterized. When real estate is community property, each spouse has a 50 percent interest. When separate property is considered, the spouse with ownership has a 100 percent interest, and the other spouse has zero.
The spouses may have a specific idea of whom they want to receive their assets when they die, but if their real estate or other property is mischaracterized, their beneficiaries may not receive what the individual thought was his or her assets. That is why it is essential that each spouse understand how their assets are titled, either as community or separate property and determine the status when putting together an estate plan.
Estate planning attorneys usually recommend that married couples transmute separate into community property. One advantage is that the surviving spouse receives a more beneficial tax basis concerning community property. When one spouse dies, their community property passes to the surviving spouse, and the property is valued as of the date of the late spouse’s death. Should the surviving spouse decide to sell the marital home not long after becoming a widow or widower, they are unlikely to pay capital gains on the sale.
Revocable Trust Warnings
More people are using revocable trusts as part of their estate plans. Their assets are placed in the name of the trust, and they can continue to use, buy and sell such assets until death. At that point, the revocable trust usually becomes irrevocable, and cannot change.
One thing couples in community property states may not realize, and this is especially dangerous with DIY revocable trusts available online, is that transferring separate property to a joint revocable trust does not make it community property. Should one spouse list their separate assets as community property assets for irrevocable trust purposes, that is not a legal transmutation. To transmute the property, the written agreement stating that the property’s status is changing is required.
What happens if the transmutation takes place and separate property becomes community property as per the irrevocable trust, and the couple later decides to divorce? In short, the property is separate no more, and the former owner of the separate property must now divide it with the former spouse.
Hire Separate Lawyers
How can you ensure your property is correctly characterized and how you should handle it? Legal counsel is needed, but not one lawyer for the couple. It is wise for each spouse to hire their own attorney, so they have someone advising and representing their specific interests. While this may cost more money in the short-term, it can save time and trouble – and finances – in the long run. When a spouse has separate counsel, arguing that they were overly influenced by their spouse or that they didn’t know what transmutation entailed is more difficult.
If a couple doesn’t want to go the separate lawyers route, their mutual attorney must receive information in writing from both spouses that they were told they could have conflicts of interest and should hire separate lawyers. Instead, they must acknowledge that they were warned of the risks and decided themselves to have a joint attorney.
Large Amounts of Separate Property
When one spouse has substantial amounts of separate property, their lawyer will likely recommend establishing separate trusts for these properties along with a joint trust for community property. Not only does establishing such trusts make it crystal clear which property is separate and which is community, but there is less chance that separate properties are commingled with community assets. For either divorce or estate purposes, such trusts show exactly how each type of property is distributed.