How Arizona’s community property laws can help families reduce capital gains taxes after the death of each spouse.
One of the most valuable—and often overlooked—estate planning benefits available to married couples in Arizona is the potential to receive a full step-up in cost basis when the first spouse dies, followed by another step-up when the surviving spouse dies.
Because Arizona is a community property state, married couples may receive significant capital gains tax advantages that are not generally available to couples who own property jointly in non-community-property states.
Understanding how these rules work can help families preserve wealth, minimize taxes, and pass valuable assets to the next generation.
What Is a Step-Up in Basis?
When you purchase an asset, such as a home, investment property, or stock, your original purchase price generally establishes your tax basis. That basis, adjusted for certain improvements and other factors, is used to calculate taxable gains when the asset is sold.
When someone dies, qualifying inherited assets generally receive a new tax basis equal to their fair market value on the date of death.
This is known as a step-up in basis, although the basis can also decrease if the property’s value has fallen. (For a broader overview, see our earlier post, How to Get a Step-Up in Basis.)
Example:
Imagine a married couple purchases an Arizona home for $200,000. Over the years, the property appreciates to $800,000.
If they sell the home during their lifetimes, they could have a $600,000 gain before accounting for improvements, selling expenses, or applicable exclusions.
However, if the property qualifies for a full step-up in basis when one spouse dies, its basis could increase to $800,000.
If the surviving spouse immediately sells the home for $800,000, there may be little or no taxable capital gain.
Why Arizona Is Different: The Community Property Advantage
Arizona is one of the states that recognizes community property ownership.
Generally, property acquired during marriage is presumed to be community property, although important exceptions apply, including certain inheritances, gifts, and property acquired before marriage (A.R.S. § 25-211). (For how community property and separate property states compare more generally, see Community Property vs Separate Property States.)
Under Internal Revenue Code § 1014(b)(6), when one spouse dies, qualifying community property can receive a basis adjustment on the entire property—not merely the deceased spouse’s half.
This is particularly important because the surviving spouse’s half of the community property may also receive a new basis.
For this special rule to apply, at least one-half of the community property’s value must be includible in the deceased spouse’s gross estate for federal estate tax purposes.
The result is a potentially substantial tax benefit for Arizona married couples.
First Death: A Full Step-Up in Basis
Consider the following example:
John and Mary are married and live in Arizona.
They purchased a rental property during their marriage for $300,000, and it is properly characterized as community property.
When John dies, the property is worth $1,000,000.
Under the federal community property basis rules, the entire property’s basis may adjust to $1,000,000.
Mary now owns the property with a substantially higher tax basis.
If she sells it shortly after John’s death for approximately $1,000,000, she may avoid most of the capital gains tax that otherwise would have resulted from the property’s appreciation.
For rental property, depreciation and other basis adjustments must also be considered.
Second Death: Can the Property Receive Another Step-Up?
Yes. In many circumstances, the same property can receive another basis adjustment when the surviving spouse dies.
Continuing our example, Mary retains the rental property after John’s death.
Over the next 15 years, the property appreciates from $1,000,000 to $1,600,000.
When Mary dies, the property is included in her gross estate for federal estate tax purposes and passes to her children.
Assuming the property qualifies under IRC § 1014, the children’s inherited basis generally becomes $1,600,000.
This means that the property has potentially received two separate basis adjustments:
- A full community property basis adjustment when John died.
- Another basis adjustment when Mary died, based on the property’s value at her death.
The children could then sell the property for approximately $1,600,000 with little or no capital gain, subject to applicable expenses, adjustments, and post-death appreciation.
Importantly, a basis adjustment does not necessarily mean that federal estate tax is owed. An asset may be included in the gross estate even when no estate tax is ultimately payable.
What Happens If the Property Is Held in a Trust?
Many Arizona couples use revocable living trusts to avoid probate, provide for incapacity, and simplify the transfer of assets after death.
However, placing property in a trust does not automatically guarantee that it will receive a full basis adjustment at both spouses’ deaths.
The outcome depends on several factors, including:
- Whether the property retains its community property characterization.
- Whether the trust is revocable or irrevocable.
- Whether the trust divides into separate trusts after the first spouse’s death.
- Whether the property is included in the surviving spouse’s gross estate at the second death.
- Whether the trust provisions preserve the intended federal income tax treatment.
A properly structured joint revocable living trust may preserve community property treatment and allow for favorable basis adjustments. (See also Do Married Couples Need One Trust or Two?)
However, certain trust arrangements can complicate the second adjustment.
What About A/B Trusts and Bypass Trusts?
Some estate plans divide assets into separate trusts when the first spouse dies.
For example, an A/B trust may create a survivor’s trust and a bypass trust, sometimes called a credit shelter trust.
A bypass trust may provide estate tax protection and other benefits. However, assets held in a traditional bypass trust generally are not included in the surviving spouse’s gross estate when the surviving spouse dies.
Consequently, those assets ordinarily do not receive another step-up in basis at the second death.
This creates an important estate planning tradeoff.
A strategy designed to minimize federal estate taxes may also cause beneficiaries to lose a potentially valuable income tax benefit.
For married couples whose estates are unlikely to be subject to federal estate tax, preserving a second basis adjustment may be more valuable than using a traditional bypass trust.
There are also more sophisticated planning strategies that may permit estate inclusion or basis adjustment under appropriate circumstances. These strategies require careful legal and tax analysis. (For an example involving a much larger estate, see A/B Trust Planning for a $30 Million Estate in Arizona.)
Does Arizona Impose Its Own Estate or Inheritance Tax?
Arizona does not currently impose a state estate tax or inheritance tax.
However, federal estate tax rules may still apply to sufficiently large estates.
For many Arizona families, the more immediate concern is not estate tax but the capital gains taxes that children or other beneficiaries may face when inherited property is eventually sold.
That makes proper basis planning especially important.
What About Property Owned as Joint Tenants With Right of Survivorship?
Not all jointly owned property receives the same tax treatment.
Arizona married couples may hold property as community property, community property with right of survivorship, or joint tenants with right of survivorship (A.R.S. § 33-431).
These forms of ownership are not interchangeable.
For example, property owned by spouses as joint tenants may receive a basis adjustment only on the portion attributable to the deceased spouse, rather than the entire property.
By contrast, qualifying community property may receive a full adjustment under IRC § 1014(b)(6).
The wording of the deed, the property’s history, and any applicable agreements can therefore make a significant difference.
What Assets May Qualify?
The community property basis rules may apply to various assets, including real estate, investment accounts, stocks, and business interests.
However, not every asset qualifies.
Retirement accounts such as traditional IRAs and 401(k)s generally do not receive a step-up in basis simply because the account owner dies. Those accounts are subject to separate income tax rules.
Similarly, property owned separately by one spouse does not automatically receive the full community property basis adjustment.
Families should review how their assets are titled and classified before assuming that a particular tax benefit will apply.
Five Estate Planning Steps Arizona Married Couples Should Consider
- Review property titles. Determine whether real estate and other assets are held as community property, joint tenancy, or separate property.
- Review existing trusts. Older trusts may contain mandatory bypass provisions that no longer align with the family’s tax planning objectives.
- Preserve community property characterization. Transfers into trusts and changes in ownership should be structured carefully to avoid unintended tax consequences.
- Evaluate estate tax exposure. Consider whether estate tax savings, capital gains tax savings, creditor protection, or other objectives should take priority.
- Maintain accurate records. Keep purchase documents, improvement records, date-of-death valuations, and other documentation needed to establish tax basis.
The Bottom Line: Arizona Couples May Have Two Opportunities to Reduce Capital Gains Taxes
Arizona’s community property laws create a valuable estate planning opportunity.
With the proper ownership structure, a married couple may receive a full basis adjustment when the first spouse dies, followed by another adjustment when the surviving spouse dies.
For families with appreciated real estate, investments, or business interests, these adjustments can potentially save beneficiaries substantial amounts in capital gains taxes.
But the benefits are not automatic.
The way assets are titled, the provisions of an estate planning trust, and the federal estate inclusion rules all matter.
At Ginsburg Law Group, P.C., we help families understand how estate planning decisions can affect their property, taxes, and beneficiaries. Whether you are creating a new estate plan or reviewing an existing trust, thoughtful planning can help protect the wealth you have worked to build.
Contact Ginsburg Law Group, P.C. to discuss your estate planning needs.
Disclaimer: This article is provided for general educational purposes and does not constitute legal or tax advice. The treatment of community property, inherited assets, trusts, and tax basis depends on individual circumstances. Consult a qualified estate planning attorney and tax professional regarding your specific situation.
