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The Tax Benefits of Community Property with Right of Survivorship Deeds Routinely married couples title their real property holdings under the joint tenancy with right of survivorship deed. Up until June 30, 2001, this was typically the best manner in which to title property because it allowed the property to pass to the surviving spouse without probate or trust administration. Instead, real property automatically transferred to the surviving joint tenant. On July 1, 2001, the California Legislature created the Community Property with Right of Survivorship Deed. This single act by the Legislature provided Californians with a major victory in the ability to obtain substantial tax savings on the sale of real property. (1) The key to the tax advantages in holding property as Community Property with the Right of Survivorship is on the tax basis rules for property. If the property is titled as Joint Tenancy with the Right of Survivorship, the basis in the property only receives a partial “step-up” in basis under IRC § 1014. If the property is titled as Community Property with Right of Survivorship, however, it receives a full “step-up” in basis to fair market value. By way of background, Tax on the sale of real property is calculated by subtracting from the fair market value of property its adjusted basis. IRC § 1014. Basis is a combination of the acquisition cost, including the debt, and any upwards adjustment for expenses that enhance the value of the real property. (2) IRC § 1011. The difference is the taxable income on the sale and if the property is held for 1 year or more, it is taxed at the capital gain rate of 15%. (3) Under Federal Tax law, in the event one joint tenant passes away, the surviving joint tenant acquires the decedent’s basis and then is permitted to adjust the basis to fair market value. IRC §1014. People have come to know this rule as the stepped-up basis rule; however, this is not entirely correct. Under IRC § 1014, the basis is adjusted to fair market value thus, the basis could be reduced or “stepped-down.” In states such as California, this rarely happens but it is possible. Under the “stepped-up” or “stepped-down” basis rules for joint tenants, only the decedent’s interest in the joint tenancy property is permitted to adjust its basis to fair market value. The surviving joint tenant’s basis remains. Therefore, the new basis in the property is only partially “stepped-up.” For example, husband and wife acquire real property for $100,000. Under the basis rules, husband and wife each have an acquisition basis of $50,000. 30 years later, husband passes away and on the date of husband’s death, the property is valued at $1,000,000. Under IRC § 1014(a), wife, as the surviving joint tenant, will continue to hold her portion of the property with the original cost basis, $50,000, but will acquire her husband’s basis of $50,000 and then adjust it upwards to $500,000. When the dust settles, wife will now have a basis in the property of $550,000. If wife sought to immediately sell the property, she would be taxed at the rate of 15% on $450,000 (the difference between the fair market value of $1,000,000 and the new basis of $550,000). Under IRC § 1014(b), an exception to the above rule applies if the husband and wife titled the property as Community Property with the Right of Survivorship. If the deed is a Community Property deed, then on the death of the first spouse, the surviving spouse is permitted to adjust both the decedents half and their half in the basis to fair market value. Continuing the above example, despite the original cost basis in the property being $100,000 and each spouse having an individual cost basis of $50,000, IRC § 1014(b) permits the decedent’s and the surviving spouses’ individual cost basis to be “stepped-up” to $500,000. Therefore, if the surviving spouse seeks to immediately sell the subject property, the tax will be significantly less and possibly $0 so long as the purchase price is equal to the new basis of $1,000,000. IRC § 1014(b) has been a part of the Federal tax code for many years and California has been a Community Property state since its days as a Spanish colony. Thus, why is this a relatively new issue. For years, the California Legislature refused to allow a Community Property title that had a survivorship feature. This forced married couples to choose a title that accurately reflected the ownership interest in the property, Community Property, or choose a title that had a survivorship feature for probate avoidance but declared the property was each spouses separate property with ½ interests. Most couples chose probate avoidance. With the Community Property with Right of Survivorship deed since 2001, couples no longer must choose between two bad options. Now, they can have a deed that permits probate avoidance on all real property and obtain significant tax benefits of a full step-up in basis. Fore more information regarding choosing the correct deed and tax issues relating to the sale of real property, please contact David J. Brillant at (925) 934-6102 or by e-mail at . (1) See California Civil Code § 682.1. (2) Whether or not an expense incurred for the benefit of real property may adjust the basis upwards can be a difficult issue. Prior to preparing a return with a basis higher than the acquisition cost, consult an accountant knowledgeable in real property transactions or a tax attorney. (3) The 15% capital gains rate is set to expire on December 31, 2007 with the old rate of 20% returning. |
