Spousal Joint Tenancies and Income Tax Basis

Overview

As a result of the Tax Cuts and Jobs Act (TCJA), the exemption equivalent of the unified credit for federal estate and gift tax purposes is presently $11.18 million.  That’s the amount for decedent’s dying in 2018 and gifts made in 2018.  There is also a present interest annual exclusion that covers the first $15,000 of gifts made to a donee in 2018.  In other words, the first $15,000 is not subject to gift tax and then additional amounts gifted to that donee by the donor start using the donor’s unified credit applicable exclusion amount.  In addition, the TCJA retained the unlimited marital deduction and income tax basis “step-up.”

The amount of the exemption means that very few people will encounter issues with federal estate or gift tax.  Indeed, for the vast majority of people, estate planning involves income tax basis planning rather than planning to avoid estate or gift tax.  Some states tax estates at death and one state retains a gift tax, and in these states the exemption is often much lower than the federal exemption.  So, for individuals in these states estate and gift tax planning can remain important for state tax purposes. 

What is much more important for most people, however, is income tax basis planning.  That’s because property that is included in a decedent’s estate at death receives an income tax basis equal to the property’s fair market value as of the date of death.  I.R.C. §1014.  As a result of this rule, much of estate planning involves techniques to cause inclusion of property in a decedent’s estate at death.  Even though the property will be subjected to federal estate tax, the value will be excluded from tax by virtue of the credit.

A great deal of property (such as farmland and personal residences) is owned in joint tenancy at death.  How much of jointly held property is included in a joint tenant’s estate at death?  That is a very important issue in the present estate planning environment.  Specifically, what is the rule involving spousal joint tenancies?

The income tax basis rules at death for spousal joint tenancies – that’s the topic of today’s post.

Joint Tenancy

A distinguishing characteristic of joint tenancy is the right of survivorship.  That means that the surviving joint tenant or tenants become the full owners of the jointly held property upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.  It’s important to note that upon a conveyance of real property, transfer to two or more persons generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.  For example, if Blackacre is conveyed to “Michael and Kelsey, husband and wife,” Michael and Kelsey own Blackacre as tenants in common.  To own Blackacre as joint tenants, Blackacre needed to be conveyed to them as required by state law.  The typical language for creating a joint tenancy is to “Michael and Kelsey, husband and wife, as joint tenants with right of survivorship and not as tenants in common.”

Estate Tax Treatment.  For joint tenancies involving persons other than husbands and wives, property is taxed in the estate of the first to die except to the extent the surviving owner(s) prove contribution for its acquisition. I.R.C. § 2040(a).  This is the “consideration furnished” rule.  While property held jointly may not be included in the “probate estate” for probate purposes, the value of that property is potentially subjected to federal estate tax and state inheritance or state estate tax to the extent the decedent provided the consideration for its acquisition.  As a result, property could be taxed fully at the death of the first joint tenant to die (if that person provided funds for acquisition) and again at the death of the survivor.  Whatever portion is taxed in the estate of the first to die also receives a new income tax basis based on the fair market value of that portion at the date of death.

Consider the following example (from my text, Principles of Agricultural Law):

Bob and Bessie Black, brother and sister, purchased a 1,000-acre Montana ranch in 1970 for $1,000,000.  Bob provided $750,000 of the purchase price and Bessie the remaining $250,000.  At all times since 1960, they have owned the ranch in joint tenancy with right of survivorship.  Bob died in 2011 when the ranch had a fair market value of $2,500,000.  Seventy-five percent of the date of death value, $1,875,000 will be included in Bob’s estate.

Bessie, as the surviving joint tenant will now own the entire ranch.  Her income tax basis in the ranch upon Bob’s death is computed as follows:

       $1,875,000 (Value included in Bob’s estate)

        + 250,000  (Bessie’s contribution toward purchase price)

       $2,125,000

Thus, if Bessie were to sell the ranch soon after Bob’s death for $2,500,000, she would incur a federal capital gain tax of $75,000, computed as follows:

       $2,500,000 (Sale price)

       - 2,125,000 (Bessie’s income tax basis)

          $375,000   Taxable gain

                    x.20    (Capital gain tax rate)

            $75,000

For joint tenancies involving only a husband and wife, the property is treated at the first death as belonging 50 percent to each spouse for federal estate tax purposes. I.R.C. § 2040(b).  This is known as the “fractional share” rule.  Thus, only one-half of the value is taxed at the death of the first spouse to die and only one-half receives a new income tax basis. 

Special rule.  In 1992, the Sixth Circuit Court of Appeals applied the consideration furnished rule to a husband-wife joint tenancy in farmland with the result that the entire value of the jointly-held property was included in the gross estate of the husband, the first spouse to die. Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992).     The full value was subject to federal estate tax but was covered by the 100 percent federal estate tax marital deduction, eliminating federal estate tax.  In addition, the entire property received a new income tax basis which was the objective of the surviving spouse.  The court reached this result because of statutory changes to the applicable Internal Revenue Code sections that were made in the late 1970s.  To take advantage of those changes, the court determined, it was critical that the jointly held property at issue was acquired before 1977.  Under the facts of the case, the farmland was purchased in 1955 for $38,500 exclusively with the husband’s funds.  The surviving wife sold the farmland in 1988 for $3,663,650 after her husband’s death in late 1987.  The entire gain on sale was eliminated because of the full basis step-up. 

In 1996 and 1997, the federal district court for Maryland reached a similar conclusion. Anderson v. United States, 96-2 U.S. Tax Cas. (CCH) ¶60,235 (D. Md. 1996); Wilburn v. United States, 97-2 U.S. Tax Cas. (CCH) ¶50,881 (D. Md. 1997).  Also, in 1997, the Fourth Circuit Court of Appeals followed the Sixth Circuit’s 1992 decision as did a federal district court in Florida.  Patten v. United States, 116 F.3d 1029 (4th Cir. 1997), aff’g, 96-1 U.S. Tax Cas. (CCH) ¶ 60,231 (W.D. Va. 1996); Baszto v. United States, 98-1 U.S.Tax Cas. (CCH) ¶60,305 (M.D. Fla. 1997). 

In 1998, the Tax Court agreed with the prior federal court opinions.  Under the Tax Court’s reasoning, the fractional share rule cannot be applied to joint interests created before 1977.  Hahn v. Comm’r, 110 T.C. No. 14 (1998).  This is a key point.  If the jointly held assets had declined in value, such that death of the first spouse would result in a lower basis, the fractional share rule would result in a more advantageous result for the survivor in the event of sale if the survivor could not prove contribution at the death of the first to die. In late 2001, the IRS acquiesced in the Tax Court’s opinion.

Conclusion

So what does all of this mean?  It means that for pre-1977 marital joint tenancies where one spouse provided all of the funds to acquire the property and that spouse dies, the full value of the property will be included in the decedent’s gross estate.  The value of the property will be subject to estate tax, but with an exemption of $11.18 million and the marital deduction, it’s not likely that federal estate tax would be due.  In addition, and perhaps more importantly, the surviving spouse receives an income tax basis equal to the date of death value.  That could be dramatically higher than the original cost basis.  If the surviving spouse sells the property, capital gain could be potentially eliminated. 

In agriculture, many situations still remain involved pre-1977 marital joint tenancies.  Be on the look-out for this planning opportunity.  It’s a “biggie” in the present era of a large federal estate tax unified credit exemption for federal estate (and gift) tax purposes.