Joint Tenancy

A recent decision of the tax court has held that the use of joint tenancy among married couples holding their community property in California will not get a step-up in basis in 100% of the property.

Married persons who hold title to their assets as community property receive a huge tax break when the first spouse passes away.  This tax break is known as “step-up in basis” and can totally eliminate all capital gains taxes on the appreciated property.

When an asset is purchased, be it stocks, bonds or real estate, the purchase price becomes the “basis” for income tax purposes of that asset.  When the asset is subsequently sold for more than the basis paid, a capital gains tax is due on the difference.  Let’s assume you purchase a stock for $10, and then you sell it two years later for $100.  The increase over your basis of $10, equal to $90, is your profit and is treated as capital gain for capital gains tax purposes.

Instead of selling the stock, let’s assume you die when the stock is worth $100.  Your estate tax liability would be determined using the fair market value, i.e. $100, of the asset in our example on the date of your death, not the income tax basis.  Since the entire estate tax liability is based on the full value, including the $90 of profit, provided your heirs get a “step-up” in basis, they may use the estate tax value of $100 for determining the gain or loss on any subsequent sale after death.  In other words, if your heirs sell the stock for $100 after your death, they will pay no income tax!

Now, if you apply the same concept to a married couple living in California who use the $10 of their community property to purchase the stock, each spouse will own 50% of that stock and have a basis of $5 for his or her interest.  In California, married couples will usually hold title to their assets in either community property or joint tenants.  If the property is held as community property, each spouse’s Will may dispose of their interest in that property when the spouse passes away.  However, if the assets are titled as joint tenancy, then the co-owners of the asset have agreed, in essence, that the survivor will own the entire property.  It is a “winner take all” proposition.  Since joint tenancy property automatically passes to the survivor, the deceased joint tenant may not dispose of his or her interest in the property by Will.

Let’s take an example of a couple who not only used community property to purchase the stock, but also held the title to the stock as community property.  Upon the death of the first spouse, that spouse’s Will leaves his or her interest in the asset to the surviving spouse.  Since the deceased spouse’s 50% interest in the asset passes to a surviving spouse, there are no estate taxes.  Even though there are no estate taxes, the deceased spouse’s 50% interest in the stock receives a step-up in basis to its date of death value, or in our example $50.  More importantly, the tax laws provide that the surviving spouse’s income tax basis in the asset owned as community property will also receive a step-up.  Therefore, as a result, the surviving spouse now owns 100% of the stock at a step-up fair market value basis of $100, thus eliminating all capital gains.

Conversely, instead of the couple holding title as community property, they now hold it as joint tenants in order to avoid probate at the first death.  Upon the passing of the first spouse, his 50% interest in the asset will pass to the survivor without having to go through probate.  Again, there are no estate taxes and the deceased spouse’s 50% interest in the asset will receive a step-up in basis to $50.  The downside to this approach is the surviving spouse’s basis of community property held in joint tenancy will not receive a step-up in basis.  The tax court has recently held that community property and joint tenancy are incompatible concepts.  Therefore, much to the chagrin of many advisors, the deceased spouse’s half of the asset will get a step-up in basis at death if the property was held as joint tenants instead of a full 100% step-up if held as a community asset.  In our previous example, the surviving spouse would have a basis of $55 (deceased spouse’s stepped-up basis of $50 and the survivor’s original basis of $5).  If the survivor subsequently sells the stock for $100, he or she will now incur a capital gains tax on the $45 of profit ($100 sale price less the $55 basis).

The lesson here is if you own appreciated community property held in joint tenancy simply to avoid probate, you are far better off to create a living revocable trust to hold your assets, thus allowing a complete step-up on the entire asset upon the first spouse’s death.