Friday, May 6, 2022
Given the current level of the federal estate and gift tax applicable exclusion amount set at $12.06 million for decedent’s dying in 2022 and gifts made in 2022, the prospect of a taxable estate at death is a concern for very few. 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 current 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 unified credit that can offset up to $12.06 million of taxable estate.
Joint Tenancy Basics
Joint forms of property holding between husband and wife have been widely used among farm families because of certain supposed advantages, one of which is the simplicity of transferring property upon death. A distinguishing characteristic of joint tenancy is the right of survivorship. That means that the surviving joint tenant or tenants become the full owner(s) of the jointly held property upon the death of a fellow joint tenant regardless of the terms of the deceased joint tenant’s will.
Upon a conveyance of real property to two or more persons, a tenancy-in-common is generally creates a tenancy in common unless it is clear in the deed or other conveyancing document that a joint tenancy is intended.
Example: Alec Trician conveys 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 of Joint Tenancy Property
Non-spousal rule. 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. 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.
Example: 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 1970, they have owned the ranch in joint tenancy with right of survivorship. Bob died in 2022 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)
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 (Tax due)
Note: While property held in joint tenancy is not be included in the “probate estate” for probate purposes, the value of the decedent’s interest in jointly held 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.
Martial joint tenancies. For joint tenancies involving only a husband and wife, the property is treated at the first spouse’s 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. Although no federal estate tax is incurred on the property passing to the surviving spouse, only one-half receives a new income tax basis equal to fair market value at the death of the deceased spouse in the hands of the surviving spouse. It does not matter which spouse provided the consideration for the spousal joint property. I.R.C. §1014.
Observation: An estate planner should carefully analyze the effect of joint property holding on basis adjustment at the death of one of the joint owners. Generally, only a one-half interest in qualified joint interests will receive a step-up in basis. However, if the first spouse to die had owned all the property, a full step-up would have been obtained.
If inception of the tenancy involved a gift by the decedent to the surviving spouse, the survivor’s basis in the property will equal the original transferred basis. As a result, the sale of the property by the surviving spouse could result in a capital gain.
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. Under the pre-Tax Reform Act of 1976 rules on joint tenancy contribution, a decedent’s gross estate included all of the value of property held in joint tenancy with another expect the portion of that value contributed by the other person, instead of arbitrarily including one-half of the value of the joint tenancy property. The surviving wife argued that there was nothing in any legislation that applied the 50 percent inclusion rule to pre-1977 joint interests, but that such interests were still subject to the full marital deduction under the 1981 Act.
The Gallenstein court reasoned that the 1976 Act applied only to joint interests created after December 31, 1976, and that the 1981 amendments which resulted in the one-half taxability expressly applied to decedents dying after December 31, 1981. The 1981 amendments did not repeal the January 1, 1977, effective date of the 1976 amendments, which did not apply to joint interests created before 1977. Because the surviving spouse as joint tenant had made no contribution to the property, she was entitled to a full step-up in basis. The result was that 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 Gallenstein 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. 140 (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. Acq, 2001-42, I.R.B. 319.
While there are estate planning drawbacks for owing property in joint tenancy at death, particularly in estates with values greater than the unified credit exemption equivalent. It also presents challenges where qualification for certain post-mortem estate planning techniques is critical, and because of it is an inflexible ownership structure. However, as the unified credit exemption equivalent has increased dramatically since 2017, joint tenancy has gained popularity. Also, 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. But, in many of these estates, the full value will be excluded from federal estate tax. More importantly, the surviving spouse will receive an income tax basis equal to the value of the property at the time of the first spouse’s death. In agricultural, many pre-1977 marital joint tenancies involving farmland exist.