A Guide to Joint Tenancy and Its Tax Effects
What is a Joint Tenancy?
In the world of estate planning, joint tenancy is a popular way to own property. Through joint tenancy, more than one individual may own property simultaneously. The interesting thing about joint tenancy is that when one owner passes away, the property automatically transfers ownership to the remaining co-owners. So, if there are three owners and one dies, the remaining two now own the property together.
How does Joint Tenancy work? How is this possible? Joint tenancy works because the individual owners have agreed to that arrangement . In fact, joint tenancy is such a powerful tool in Texas that courts will presume that joint tenancy exists between owners if there is any evidence of a gift or settlement between the co-owners (such as having paid a portion of the purchase price) and the joint tenancy is in question. For instance, if a married couple purchases a home, it is presumed that they took title as joint tenants. The benefit is evident – upon the first death, the ownership of the home avoids probate.
The equality of the co-owners is a cornerstone of joint tenancy. All joint tenants have an equal ownership and an equal right to possession of the property. So if one owner wants to sell their interest in the property, the other co-tenant receives the fair value of the property without that co-tenant anywhere else.
Tax Effects of a Joint Tenancy
When property is held in joint tenancy, the tax implications for gifts or inheritance need to be analyzed to determine whether a tax is owed. Generally, when property is given as a gift, a tax may be owed on the fair market value of the property exceeding the annual and lifetime gift exemptions allowed to the donor. When someone inherits property, the fair market value of the property on the date of death of the decedent establishes the basis for the property (i.e., the starting point for calculating gain or loss on a future sale). If the property was joint tenancies, the policy that one-half of the fair market value is a gift from the decedent to the other joint tenant is applied to determine the cost basis of the property and the amount of any gift tax due.
When only one joint tenant files the income tax return, the IRS will not prosecute a joint tenancy over the income. Both joint tenants are given equal control of the property made part of the joint tenancy, so the IRS takes the position that each joint tenant benefited equally from the use of the income or property. However, if it is determined that the joint tenancy was used as a tax shelter, the IRS may try to collect the tax from only the highest income party.
Estate Tax Effects
With all the attention on the potential estate tax exemption amount of $10 million for any one taxpayer, or $20 million for a married couple, all taxpayers should pay closer attention to a widely used "tax trap," which can unwittingly snare them, resulting in significant estate tax liability.
Most clients have heard of and understand a basic "joint tenancy" between husband and wife, in which the surviving spouse inherits the couple’s community property without the need to go through probate.
"Joint tenancy with rights of survivorship" is a type of co-ownership of property by two or more persons. Upon the death of one of the co-owners, that owner’s interest in the property pass to the surviving co-owner(s) via the right of survivorship, and not through the deceased owner’s will. Upon the death of the last joint tenant, the decedent’s estate becomes liable for estate taxes on the fair market value of the property on the date of death.
Joint Tenancy With Right Of Survivorship. It is important to understand that, in this type of joint ownership, the decedent who owned the property is deemed to own an undivided interest in the property, which must be included in his or her estate upon the decedent’s death. The survivor(s) do not own an interest in the property, and thus do not include their share of the property in their own estate. Consequently, the joint tenant’s executor or heirs will be required to pay estate tax on the property upon the death of the decedent joint owner.
Presumptively Equal Contribution. When a surviving joint tenants’ interest in the jointly owned property is challenged, it is presumed that the decedent joint tenant contributed equally to the acquisition of the property. Furthermore, there is a presumption that the survivor of the joint tenants took the decedent’s contribution as a gift at the time the property was acquired. This means that the survivor has the burden of rebutting the presumptions of equal contribution and gift. If the survivor proves that he or she contributed all of the purchase price of the property, then nothing will be included in the estate of the deceased joint tenant. Conversely, if the survivor fails to rebut these presumptions, then half of the fair market value of the property as of the death date will be included in the estate of the decedent joint tenant. Thus, in effect, the survivor of the joint tenancy receives a step-up in basis as to the surviving joint tenant’s interest (one half) of the property, but half of the value of the decedent’s vested interest is pulled back into his or her estate also. If the survivor receives his or her interest through the decedent’s will, then the entire value of the property will be included in the survivor’s estate.
Lifetime Gifting Strategy. A strategy which may calm the client’s fears of the possibility of losing the couple’s home to the high cost of nursing care, and which may also save the couple significant real estate transfer taxes, is an inter vivos gift of one-half of the couple’s home, or other joint property, as long as there are no substantial costs associated with selling or transferring the gifted asset.
There are several estate tax planning approaches to minimize the estate tax consequences of joint tenancies.
A client should review all joint tenancies in which he or she may be legally or beneficially involved. If the client is a party to joint tenancies with rights of survivorship, he or she should consider: In conclusion, be aware of the potential adverse estate tax consequences of joint tenancies. Pre-transfer planning can reduce the risk of adverse tax consequences upon death, result in a step-up in basis for surviving joint tenant, and reduce or eliminate the incidence of or power of attorney abuse.
Capital Gains Tax in a Joint Tenancy
The capital gains tax consequences of a gain or loss on the sale of property held in joint tenancy are resolved by determining each tenant’s share of the basis (or basis) of the property. The sale price is reduced by the calculation of a combined basis and then separately apportioned to the various tenants. Each tenant’s share of a capital gain is calculated using the ratio of his/her/its share of the property basis divided by the old basis as the new basis for the calculation. This approach is set forth in IRS Rev Ruling 54-438, published on 4-12-1954. It was based on a lawsuit which had not fully resolved the issue of taxation but it was enough of a precedent that it should provide some comfort in the same set of circumstances.
For example, husband and wife own a rental house in joint tenancy that they have owned for 25 years. When they bought it, it cost $80,000. At the time they sell it, its fair market value (FMV) is $370,000 . When they sell it, therefore, there is a $290,000 capital gain ($370,000 – $80,000 = $290,000). Dividing the combined capital gain of $290,000 by the old basis of $80,000 results in an apportionment to the taxpayer of 3.625 times his old basis ($290,000 รท $80,000 = 3.625). As a result, when Husband sells the rental property, his basis is $80,000 and his share of the capital gain on the joint tenancy rental property is $80,000 x 3.625, or $290,000 x 3.625 times 50%, or $104,375. The same calculations are performed with respect to Wife resulting in $104,375 being her share of the capital gain. In the same example but upon the death of one of the joint tenants, the surviving spouse would be deemed to have acquired his/her partner’s share of the old basis and, as a result, the death of one joint tenant will under applicable principles of estate tax law result in a basis step-up for the decedent’s half of the basis to FMV. Note that the basis is indexed for inflation when determining capital gain.
Joint Tenancy and Alternatives to Tenancy
A joint tenancy distinguishes itself from other forms of property ownership both in form and function. For estate planning purposes, the legal form that gives rise to a joint tenancy is most important as it is essential to obtain the tax benefits ordinarily associated with joint tenancy property. Without question, joint tenancy property should be owned in the name of the spouse who will not die first.
The most common forms of co-ownership are (1) joint tenancy, (2) tenancy in common, and (3) community property. Tenancy in common is often described as the standard form of ownership by two or more persons. The typical example is brothers and sisters buying real estate as investment property or a vacation home. Unless otherwise expressly stated, presume that the property is held in tenancy in common and not joint tenancy. A tenancy in common exists because the brothers and sisters wish each survivor to benefit equally from the use of the property during their respective lifetimes without concern that sale proceeds will be automatically distributed to the other owner(s) on the death of each brother or sister. Unless the joint tenancy form of ownership is used, the death of one tenant-in-common will result in his/her one-half share being inherited by his/her estate. Thus, the death of one tenant-in-common will result in the shares of each tenant-in-common being divided and then recombined into a single joint estate which will be treated as a new tenancy-in-common with the decedent’s heirs.
Another form of ownership available in California is "community property with the right of survivorship." This hybrid form of ownership combines the best of both worlds – the ease of joint tenancy ownership with the advantages of community property taxation. It constitutes a unique form of property ownership only available in California and nine other states which community property taxation is allowed. If the property tax advantages of community property do not apply in your state of residence, then you should delay using a community property with right of survivorship until you need to enjoy the estate tax saving advantages of joint tenancy.
Property owned in joint tenancy does not determine how a gift to each other is to be made. Thus, it is not unusual for a married couple to own some property as joint tenants while acquiring other property as tenants-in-common. This frees the couple to make gifts of their portion of the jointly owned property to each other while leaving the deceased spouse’s share to his/her estate or heirs.
Legal and Financial Planning Strategies
Financial advisers must be prepared to address issues that are unique to joint ownership. Owners who cohold property (including checking and savings accounts) as joint tenants are, in many jurisdictions, entitled to immediate access to all of the assets in the account. But when one owner dies, the survivor has full legal ownership of the property and on occasion others do not know that the deceased owner’s estate is entitled to the other half of the property’s value. Joint owners who borrow from the account may have difficulty getting credit of payment for amounts repaid . The death of a joint tenant may change the beneficiary of life insurance or retirement accounts. Surviving owners may be able to choose a different tax year, which can affect estate taxes.
At the time of the creation of joint ownership, clients should anticipate how the resulting tax effects might impact their estate plans. They might want to equalize assets held in joint tenancy with other property they own so the full probate estate is appropriately share among heirs. We recommend that clients work closely with legal and tax counsel to ensure each owner fully understands the implications of owning property in joint tenancy.