Did you relocate or retire to Arizona from a state that does not have community property? (There are only 8 community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas and Washington.)

If so, it might be worthwhile to review your estate plan to see if you can utilize Arizona's community property law to save taxes on your estate.

Under Arizona law, assets held by spouses as community property are owned one-half by each spouse, and federal tax law follows this principle by including only one-half of the value of property owned by spouses as community property in the estate of a spouse upon his or her death. Property acquired by spouses while living in most jurisdictions not recognizing community property may be owned entirely by the spouse in whose name it is held upon his or her death as a resident of Arizona. Thus, there is a risk, where most of the property of a married couple is held in only one of their names, that the other spouse will not be able to take full advantage of the estate tax exemption, and, as a result, their combined assets will bear more tax before passing to their heirs than if their estates had been equalized though its treatment as community property.

One way to accomplish such equality is to "transmute”, or change the character of, the separate property of each spouse to the community property of both spouses. There is no tax on such a transaction, since virtually all transfers between spouses qualify for the unlimited marital deduction.

For example, if John and Mary Smith have moved to Arizona from Colorado with combined assets of $3 million, of which $2.5 million is in John's name, if Mary dies first, there are not enough assets in her name to use up the full current exemption amount of $1 million. Although there will be no tax on her death if she leaves everything but the $500,000 in assets in her name to John, upon his death, his taxable estate is $1.5 million after application of his exemption.

If he and Mary had owned the $3 million as community property, $1 million of Mary's one-half interest in those assets could have been excluded from taxation at Mary's death, in addition to what she left to John, and another $1 million would be excluded at John's death, leaving only $1 million subject to tax. With tax rates starting at 41%, leaving title as acquired in Colorado unnecessarily would have reduced the net inheritance received by their heirs by roughly $200,000.

For larger estates, the risk of heavier taxation due to inequality in the value of the respective estates of spouses will increase as the exemption amount goes up in the next few years. It increases to $1.5 million in 2004, to $2 million in 2006, and to $3.5 million in 2009, before the estate tax is repealed for one year only in 2010 (after that, the exemption returns to $1 million).

Of course, transmutation assumes that the marriage is secure. If there is a possibility that the marriage could be terminated prior to death, transmutation of property to community property could work to the disadvantage of the spouse in whose name it previously was held, depending upon how it was acquired.