Nicole R. Takemoto of Hartog, Baer & Hand.

Married couples often don't give much thought to the characterization of their property as community or separate. In general, community property is all real or personal property acquired by a married person during the marriage. Separate property is all property owned by the person before the marriage, all property acquired by the person after marriage by gift, bequest or devise, and the rents and profits from the person's separate property.

The day to day routines of the spouses sometimes do not reflect the true character of the property. For example, many couples treat their residence as a joint asset even if it is the separate property of one spouse. Their actions may include sharing property expenses such as taxes, insurance and maintenance costs, or jointly contributing to major improvements. Although the couple may treat this residence as a community property asset, their behavior alone does not change the character of the property.

Transmutation is an interspousal agreement or transfer, with or without consideration, that changes the characterization of property. Transmutation can accomplish any of the following: 1) transmute community property to separate property of either spouse, 2) transmute separate property of either spouse to community property or 3) transmute separate property of one spouse to separate property of the other spouse.

Each community property state has its own rules regarding the effective transmutation of property. In California, spouses can transmute property by written agreement. The agreement must expressly state that a change in the characterization or ownership of property is being made, but the agreement need not use the word transmutation or any other particular term. The spouse adversely affected by the transmutation must sign the agreement.

Transmutations can also be inadvertent. For example, assume that a couple owns their residence as community property. They would like to refinance the property, but one of the spouses has bad credit. This spouse signs a quitclaim deed to transfer his interest to the other spouse, with the understanding that the property will later be transferred back to both spouses after the refinance. The property is never retitled and the spouses file for dissolution of their marriage. At dissolution, the residence is the separate property of one spouse.

All is not lost in the example above. When a transmutation results in one spouse obtaining an economic advantage at the expense of the other spouse, there is a presumption that the transaction is invalid due to undue influence. The advantaged spouse must show that there was no undue influence. To rebut the presumption of undue influence the advantaged spouse must show: 1) the transfer was made freely and voluntarily, 2) the transfer was made with full knowledge of all the facts and 3) the transfer was made with a complete understanding of the effect of the transfer. The spouse must provide evidence of the intentions and understanding of the spouses at the time of the transfer.

Proper characterization of property is crucial when spouses establish an estate plan. Each spouse controls the disposition of their one-half interest in community property and all of their separate property. If the spouses do not have a clear understanding of the characterization of their assets, the ultimate division of their assets at death or divorce could be far different from what they intended.

As part of estate planning discussions, married couples are often advised to transmute separate property to community property. This will allow the surviving spouse to receive the advantage of the tax basis adjustment applicable to community property at the death of the first spouse (the “deceased spouse”). The entire tax basis of a community property asset is adjusted to the fair market value of the property at the deceased spouse's death. Therefore, there will be little to no capital gain if the surviving spouse sells the property soon after the deceased spouse's death.

A revocable trust is the cornerstone of most estate plans. A general provision in the trust providing that all property transferred to it is community property is not an effective transmutation. There is no transmutation when spouses transfer property to their joint revocable trust or if a spouse lists a separate property asset on a schedule of community property trust assets. If the spouses wish to transmute property, they should first enter into a written agreement containing an express statement that a change in characterization is being made. While the tax basis adjustment for community property is attractive to many couples, they must understand that the transmutation is valid in the event of divorce. The spouse who originally owned the separate property will now have to divide the property with the other spouse.

There are several ways to reduce the risks of characterization related property disputes. It is ideal for married clients to have independent counsel to advise them separately about the benefits and risks of transmutation. This arrangement would make it more difficult for one spouse to assert that he didn't understand the consequences of transmutation or he was unduly influenced by the other spouse to make a transmutation.

Where independent representation is impractical, the attorney should obtain written acknowledgement from the spouses that they were warned about potential conflicts of interests and advised to seek independent legal advice, but nonetheless accepted the risks and agreed to joint representation.

Attorneys should encourage spouses with significant amounts of separate property to establish separate trusts for their separate property and a joint trust for their community property. This planning structure reinforces property characterization, reduces the risks of commingling and creates a clear plan of property distribution for each category of property.

Nicole R. Takemoto is an associate in Hartog, Baer & Hand's estate planning and trust administration group. She can be reached at [email protected].