What is the best form of co-ownership between husband and wife? Is it best to hold title to your home or other assets as joint tenants or as community property? Consider that there may be unintended tax consequences before you decide.

WHAT IS INCOME TAX “BASIS?”

Basis is generally the amount of your capital investment in property for tax purposes. In most situations, the basis of an asset is equal to the amount that the asset cost to acquire, plus any improvements. There are two methods for determining basis: “carryover” and “step-up.”

Carryover basis occurs when a property transfer also results in a transfer of the transferor's basis in the property. This happens when property is gifted during the lifetime of the transferor. The transferor's basis in the property "carries over" to the property recipient. By way of illustration, if you gifted property to a sibling during your lifetime, your sibling would use your capital investment amount to calculate realized gain for tax purposes. On the other hand, the basis of inherited property is equal to the property’s fair market value on the date of death of the transferor. This is often referred to as “stepped-up” basis. Rather than the basis remaining at the decedent’s investment amount, the person receiving the property gets a step-up to fair market value. The step-up creates an income tax advantage because the beneficiary will not have to pay income taxes on realized gain.

Basis is an important factor in determining how married couples should hold title to their home because, depending on the form of ownership, you may or may not be able to take advantage of a step-up in basis should you outlive your spouse.

JOINT TENANCY

Joint tenancy is a form of ownership commonly used to title property between spouses because no probate is required at the death of the first spouse. Rather, the survivor simply inherits the decedent’s share of the asset resulting in 100% ownership interest. It is created by simply adding the words “joint tenancy” in the title documents. Joint tenancy is a straightforward probate avoidance tool because California does not require a formal court proceeding to confirm the transfer. It is automatic at the death of one joint tenant.

Joint tenancy is generally not recommended for married couples who own assets that can increase in value, such as a residence, because the U.S. Internal Revenue Code does not allow the surviving joint tenant to receive a "step-up" in cost basis to fair market value at the date of death of the spouse. For assets held in joint tenancy, stepped-up valuation applies only to the deceased partner's share of the property. For example:

Fred and Mary are married and hold title to their home as joint tenants. Their home has a basis of $300,000 (purchase price plus improvements) and fair market value of $500,000. If Fred dies, Mary inherits the property without probate and has a new stepped-up basis, calculated as follows:

Fred’s share (stepped up value): ½ of $500,000 = $250,000

Mary’s share (basis value): ½ of $300,000 = $150,000

New basis value: $250,000 + $150,000 = $400,000

After Fred’s death, if Mary immediately sold the home she would owe capital gains on $100,000; representing the difference between fair market value of $500,000 and the adjusted basis amount of $400,000.

COMMUNITY PROPERTY

Community property is also a form of co-ownership but is applicable only between husband and wife. Like joint tenancy property, each spouse’s interest in community property is equal during their marriage. Unlike joint tenancy, however, each owner has the right to dispose of his/her one half of the community property by will. Thus, each spouse’s one-half community property interest may be subject to probate or similar proceeding to transfer title to the surviving spouse.

The U.S. Internal Revenue Code provides special treatment for property owned by a married couple as community property. When a married couple owns an appreciated asset as community property, the surviving spouse is allowed a step-up in basis to fair market value at the date of death of the other spouse. Consequently, if the surviving spouse must sell the residence, he or she is not likely to incur any capital gains. For example:

Fred and Mary are married and hold title to their home as community property. Their home has a basis of $300,000 and a current market value of $500,000. If Fred dies, Mary inherits the asset and has a new stepped-up basis for both Fred's and Mary's share of the assets:

Fred’s share (stepped up value): ½ of $500,000 = $250,000

Mary’s share (basis value): ½ of $500,000 = $250,000

New basis value: $250,000 + $250,000 = $500,000

After Fred’s death, if Mary immediately sold the home she would not owe capital gains because the fair market value equals her basis of $500,000.

CONCLUSION

Many married couples have their home titled as joint tenants. This can create a problem when one spouse dies, and the survivor later sells the property because only the decedent’s portion of the property gets the step-up. The basis adjustment is limited to the decedent’s one-half interest. The community property survivor, on the other hand, gets a step-up in basis at the death of the first spouse potentially creating significant income tax savings if the survivor sells the property.

In order to capture the best of both situations, it is possible to transfer property into a “revocable trust” (thus avoiding any probate court proceedings) while also retaining its character as “community property” (thus obtaining a full “adjusted basis”).

Call the Law Office of Lynn K. Girvin to learn more about estate planning and what manner of titling your home best fits your situation (714) 619-4145!

© Law Office of Lynn K. Girvin

*This discussion is intended to provide you with general information about income tax basis and does not include all the variables in determining how your estate plan should be prepared. This handout is not intended to provide tax advice or legal opinions. Before making and changes to your estate plan you should consult with your estate planning attorney and tax advisor to determine the best options for you and your family.