A woman recently called me with a dilemma. Her husband passed away last year and she’d like to sell her large house in Redwood City and buy a small condo. Her kids moved out many years ago and she’s having a hard time going up and down the stairs. She and her husband bought the house almost 40 years for what now seems like almost nothing. Today it’s worth a small fortune.
Here’s the problem. If she sells the house, she’ll be paying the government a hefty sum on the capital gains. This is despite the fact that she has a $250,000 tax exemption. She would have had a $500,000 tax exemption if she sold the house in the year her husband died. Silly IRS rule. In any event, she would owe a bunch of money – money that she now needs more than her long lost Uncle Sam. Had she and her husband done a very simple thing, she likely would not be on the hook to pay any taxes.
Meet The Fictional Albert and Bonnie
Albert and Bonnie are married. In 1985 they buy an investment property for $100,000 and take title as Joint Tenants. Fast forward to 2005 – Albert dies. It’s sad. But when he dies, the property is worth $700,000. If Bonnie sells, she would pay capital gains on $300,000 because she only receives a step-up in basis on Albert’s half interest in the property. Bonnie’s basis hasn’t changed. If they depreciated the property over the years, the taxable gain would be even greater than $300,000.
Let’s say Bonnie keeps the property and dies in 2016, when the property was worth $1.5 million. Whoever inherits the property from Bonnie will get a step-up in basis on Bonnie’s one-half interest, which would be $700,000. They would still have to pay capital gains tax on the $300,000 that was not stepped-up since Albert’s death. Again, assuming Albert and Bonnie depreciated the property over the years, the capital gain would be greater than $300,000.
If, however, Albert and Bonnie simply held title to their property as Community Property With Right Of Survivorship, Bonnie would have received 100% step-up in basis on Albert’s death – not just on Albert’s one-half interest. So if Bonnie sold, she would not pay any capital gains tax. And if Bonnie held on to the property for the rest of life, whoever inherited the property from Bonnie would get another 100% step-up in basis. They too would be able to sell without incurring a tax liability.
Joint Tenancy vs. Community Property With Right Of Survivorship
As you can see, the way you and your spouse hold title to real estate may have some serious financial implications. Typically, married couples hold title either in Joint Tenancy or Community Property With Right Of Survivorship. Joint Tenancy is a form of co-ownership in which two or more people, usually a married couple, have an equal coexisting right to an undivided one-half interest in the property. It’s really a form of separate property, meaning that each spouse has a separate property interest in one-half of the property. Right of Survivorship is the key feature of a Joint Tenancy, meaning that joint tenant A’s interest immediately goes to joint tenant B when joint tenant A dies. The surviving spouse immediately becomes the sole owner of the property. Nothing more is required for this to occur – a formal probate proceeding is not required. Seems okay, right?
Then there’s a little thing called Community Property With Right Of Survivorship, which is a relatively new way for married couples to hold title to property in California. It’s essentially a combination of Joint Tenancy and Community Property, allowing property that was deeded after July 1, 2001 to also pass to the surviving spouse without having to go through probate. The IRS traditionally views Community Property as each spouse owning the entire property while they are alive (not a separate one-half interest). The problem with owning property simply as Community Property is that there is no Right of Survivorship benefit – meaning that the property must go through probate on the death of a spouse. That’s because each spouse is free to leave their share of the Community Property to whomever they choose. It does not automatically go to the surviving spouse. So the California legislators passed what is now known as Civil Code section 682.1, providing a survivorship benefit which has historically been available only in Joint Tenancies.
On the surface, it doesn’t appear to make a difference if title is held in Joint Tenancy or Community Property With Right of Survivorship. In fact, there is no real practical difference in the taxation of income between the two while both spouses are alive. The difference may be huge, however, after the death of the first spouse.
When one owner of Joint Tenancy property dies, only that owner’s share of the property receives a step-up in basis because the property is treated as the separate property of each spouse for IRS purposes. So if the surviving spouse sells the property, one-half of the appreciation that accrued from the time they purchased the property to the date the first spouse died will be taxed as a gain. However, if the married couple held title as Community Property with a Right of Survivorship, the property receives a 100% step-up in basis for tax purposes. This allows the surviving spouse to avoid probate and sell immediately with no taxable proceeds from the sale. Here in the Bay Area, that could be a huge tax savings.
Here’s the kicker. If the property is titled as Community Property With Right Of Survivorship and the surviving spouse (Spouse B) held onto the property, then there would be another step-up in basis. This means that whoever inherits the property from Spouse B will get the entire property with the fair market value basis. That’s a 100% step-up again. Unfortunately, if the property was titled in Joint Tenancy when Spouse A died, whoever inherits the property from Spouse B will get a step-up in basis only on Spouse B’s one-half interest and will probably have to pay the dreaded capital gains tax.
The point of this story is this: If you own real estate, look at your deed. If your parents own real estate, tell them to look at their deed too. And be sure to have an estate plan.