Joint tenancy ownership - advantages and pitfalls.by Lassila, Dennis R.
When an individual dies, some or all of his property may have to be probated. Probate is a court supervised collection of the decedent's property, payment of the liabilities, payment of death taxes, and distributions of remaining property to beneficiaries or heirs. While probate can serve useful functions such as clearing title and settling competing claims to property, it can be expensive and time consuming. Further, probate exposes a person's estate to publicity and public scrutiny. For these reasons, taxpayers have sought to avoid probate through means such as living trusts, life insurance policies, and the joint ownership of property with another with the right of survivorship. This article covers joint ownership of property with the right of survivorship including its advantages, tax consequences (estate, gift, and income tax), disadvantages, and pitfalls. These matters should be carefully evaluated by estate planners and other professionals in advising clients concerning its use.
Advantages of Joint Tenancy with the Right of
The advantages of joint tenancy and tenancy by the entirety are that it is simple to arrange, and that, at the death of all joint tenants except the last one, title to the jointly-held property passes to the surviving joint tenant without the delay, expense, or legal entanglements and confusion of probate. Individuals (particularly husbands and wives) typically enter into joint tenancy property ownership arrangements because they are easy to set up and can avoid probate. Further, it is often thought that husbands and wives should each have a formal legal interest in marital property. Joint tenancy ownership can provide such formal legal interests for both spouses. Unfortunately, many individuals enter into joint tenancy property ownership arrangements because of these factors without a consideration of the tax consequences and disadvantages associated therewith. These issues are discussed in the remainder of this article.
Estate Tax Consequences
The estate tax consequences associated with joint tenancy ownership of property depend upon whether the property is held jointly by a married couple or by other individuals. A related question is the income tax basis the surviving tenant(s) receive in the property upon the death of a joint tenant.
Husbands and Wives--Tenancy by the Entirety. Under IRC Sec. 2040(b) only one-half of the value of property held in joint tenancy by husband and wife is included in the gross estate of the first spouse to die. And even that amount is not subject to estate tax because it will be deductible under the unlimited marital deduction provisions of Sec. 2056. Thus, at first blush it appears that the estate tax consequences associated with joint ownership of property by husband and wife are simple and quite favorable. However, there are two glitches to be taken into account: 1) the income tax basis for the surviving spouse in the jointly-held property; and 2) the impact of jointly-held property on the use of the unified transfer tax credit of Sec. 2010.
Because only one-half of the jointly-held property is included in the gross estate of the deceased spouse, the related income tax basis rules permit a step-up in basis to the date of death value on only one-half of the property. That is, only half of the property will take a basis equal to the property's fair market value (FMV) at the date of death of the deceased spouse. The other half of the property will keep the basis it had while both husband and wife were alive. On the other hand, if the property had been separately owned by the deceased spouse and had passed to the survivor by will, the basis of the property in the hands of the surviving spouse would be the FMV of the entire property. Overall, then, the joint ownership of property by husband and wife can leave the surviving spouse at a substantial disadvantage income tax- wise, especially if a sale of the property is anticipated soon. This is especially true today when net long-term capital gains are taxed at the same rates as ordinary income.
Example 1: Martin and Mary Jones owned Blackacre as joint tenants. Martin paid $80,000 for Blackacre in 1983 and placed the property into joint tenancy ownership with his wife Mary. No gift taxes were payable since the unlimited gift tax marital deduction applied. Martin died in 1987 when Blackacre was worth $200,000. Mary's income tax basis in Blackacre is $140,000 (1/2 of $80,000 plus 1/2 of $200,000). Thus, if Mary sold Blackacre for $220,000 in 1988, she would have a gain recognized of $80,000 ($220,000 minus $140,000), upon which she would pay income tax of $22,400, assuming that her marginal income tax rate is 28% for 1988. If the property had been kept in separate ownership by Martin and then passed to Mary by will, Mary's basis would have been the full $200,000 date of death value. In that case, she would have a gain on the sale of only $20,000 ($220,000 minus $200,000) rather than $80,000, and her income tax would be $5,600 (28% of $20,000) rather than $22,400; a tax savings of $16,800.
Note that when the jointly-held property is the primary residence of the husband and wife, the Sec. 121 one-time exclusion can act to shield the surviving spouse from recognizing some or all of the gain that would result upon the sale of the residence. Thus, the rules of Sec. 121 can ameliorate the income tax basis consequences to the surviving spouse. In other instances, the nontaxable exchange rules of Secs. 1031, 1033, and 1034 can limit or eliminate the consequences of the survivor basis rules if the surviving spouse transfers property in a transaction that is covered by one of these sections.
Use of the Unified Transfer Tax Credit. The unified transfer tax credit of $192,800 can shield about $600,000 of property held by a decedent from estate tax. In the case of a married couple, up to $1.2 million of marital property can be shielded from estate tax due to the unified credit. If the assets held by a married couple equal or exceed $1.2 million in value while both spouses are alive, it is common to have a provision in the will of the owner-spouse leaving $600,000 of the property in trust for the benefit of persons other than the surviving spouse to make certain that the unified credit is fully used at death of the first spouse. The rest of the property can be left outright to the surviving spouse or placed into a marital trust. This strategy can minimize the estate taxes payable by the estates of both spouses.1 However, if a large amount of property is held in joint tenancy, it may not be possible to fully use the unified credit of the first spouse to die. That is because the jointly-held property will pass to the surviving spouse regardless of the provisions in the will of the first spouse to die. In such a case, some or all of the first spouse's unified credit will be wasted, and more property will be subject to estate tax in the second spouse's estate.
Example 2: Mike and Carol Baker jointly own $1.2 million of property and Mike owns $200,000 separately (which is to be left to their children). Ignoring the deduction for debts, funeral expenses, and the state death tax credit, if Mike dies first, the $1.2 million of jointly- held property will pass automatically to Carol and be eligible for the marital deduction and only $200,000 will be shielded from tax by Mike's unified credit. The rest of Mike's unified credit is wasted.
To avoid wasting any of the unified credit, spouses should consider terminating the joint tenancy ownership status on some or all of the jointly-held property. Terminations will be covered later.
Joint Tenancy Ownership by Nonspouses
If property is held in joint tenancy by persons who are not husband and wife, the estate tax consequences are more complex than for those who are married. The estate tax treatment depends upon whether the joint owners acquired the joint ownership interest through gift, bequest, devise, or inheritance from a third party or if the joint ownership arises through some other means, such as the purchase of the jointly-held property by one or more of the joint tenants.
Property Acquired by Gift or Inheritance. If the jointly-held property was acquired by the deceased and surviving tenants by gift, bequest, devise, or inheritance from a third party, only the value of the fractional interest held by the deceased tenant is included in his gross estate. In general, the value of the decedent's interest is determined by dividing the total FMV of the property by the number of joint owners, unless the deceased tenant's interest is specified or fixed by local law. For example, if the deceased tenant and his three sisters received jointly-held property as a gift from their grandparents, only one-fourth of the value of the property would be included in the decedent's gross estate.
Joint Ownership Created by Means Other Than Gift or Inheritance from a Third Party. If jointly-held property is not acquired by gift or inheritance from a third party, the general presumption is that the entire value of the jointly-held property is included in the gross estate of the first joint tenant to die, unless the executor of that decedent's estate can prove that the decedent did not furnish all of the cost of the jointly-held property. If the executor can prove that the other tenants furnished some or all of the consideration, then the amount included in the decedent's gross estate will equal the FMV times 100% minus the percentage of the consideration furnished by the surviving tenants. Thus, if it can be shown that the decedent contributed none of the consideration, no amount will be included in the decedent's gross estate.
Example 3: Mike and John purchased Greenacre in 1983 to be held in joint tenancy with the right of survivorship. Mike paid $50,000 and John $30,000. Mike died in 1988 and Greenacre was worth $200,000 of the time of his death. The amount included in Mike's gross estate is $125,000 or $200,000 times 62.5% (100% minus the 37.5% contributed by Mike--30/80).
Obviously, this rule necessitates that taxpayers keep records, including receipts showing consideration furnished by each tenant when property is purchased and jointly-held.
Gift Received from the Decedent as Consideration. In determining the amount of consideration furnished by the surviving tenant, if the other tenant(s) acquired property for no consideration (e.g., by gift) and later used that same property to furnish part of the consideration for other property to be held in joint tenancy with the now deceased tenant, the surviving tenant is not considered to have furnished any of the consideration. That is because the surviving tenant did not, in reality, do so; instead, the deceased tenant provided all of it. The same rules occur in a case where the property given to the surviving tenant by the deceased tenant had appreciated in value before it was furnished as part of the consideration for the jointly-held property.
Example 4. In 1980, Walter gave Samuel some XYZ Co. stock worth $10,000. In 1983, when the stock was worth $15,000, it was furnished by Samuel as one-half of the consideration to purchase land to be held in joint tenancy with Walter. Walter died in 1988 when the land was worth $90,000. All $90,000 is included in Walter's gross estate.
However, if the consideration furnished by the surviving tenant consists partially or totally of ordinary income (e.g., dividends) attributable to property that had been received from the decedent by gift, the amount of the ordinary income so used is treated as consideration furnished by the surviving tenant under Reg. 20.2040-1(c), Example 5. The same treatment has been accorded to the amount of a gain realized on the sale by the surviving tenant of property received as a gift from the decedent, where the gain is used as consideration in the acquisition of a joint tenancy property interest.
Example 5. Assume the same facts as in Example 4 above, except that Samuel sold the XYZ Co. stock that had been given to him by Walter for $15,000 in 1983 and that in 1984, Samuel used the $15,000 as his part of the consideration in the acquisition of jointly-held property with Walter. The $5,000 gain ($15,000 minus $10,000) on the XYZ Co. stock will be treated as consideration furnished by Samuel toward the purchase of the jointly-held property.
However, in a case where the proceeds from the sale of the gifted property (including the gain) were placed by the surviving tenant into a joint bank account with the deceased tenant and the amount in the bank account is later used to acquire property to be held in joint tenancy, the surviving tenant will not be treated as having furnished any of the consideration. As compared with the estate tax treatment (described previously) applying to the case where the surviving tenant keeps the sale proceeds including the gain and later uses the proceeds as his consideration toward the purchase of the jointly-held property, this treatment seems unfair and misplaced. The distinction between the two cases is hardly more than nominal.
An analysis of the instances where some or all of the consideration used by the surviving tenant is in the form of or results from property received gratuitously from the decedent necessitates careful record- keeping of the amount and the use of any ordinary income attributable to that property and any gains resulting from its sale. Where possible, the ordinary income and gain amounts should be used to the greatest extent possible as consideration if other property is to be acquired and jointly-held with the person from whom the property was received. Such amounts should not be placed in a joint bank account with the decedent.
Mortgages as Consideration. In cases where the jointly-held property is subject to a mortgage or other liability, each joint tenant is deemed to have contributed a share of any joint unpaid original liability indebtedness to which the property is subject as well as mortgage indebtedness paid by the co-owner. Further, the unpaid balance of any indebtedness that is secured by refinancing the jointly-held property or a second mortgage is treated as equally contributed by the co-owners if the indebtedness is used to improve the property.
Services as Consideration. In certain cases, the deceased tenant's executor has asserted that value of the surviving tenant's services performed with respect to the jointly-held property should be treated as consideration furnished by the surviving tenant. In general, the cases involving the question of whether the surviving tenant's services with respect to joint tenancy property relate to services performed by the deceased tenant's wife. While these cases have no relevance today for husband and wife joint tenancies, some of the rulings may have relevance in the case of nonspousal joint tenancies. For instance, courts have ruled that a wife's non-domestic services (e.g., performing chores on a family farm) were consideration furnished where there was an agreement between the spouses to share profits, and in particular where the wife made a money contribution at the start of the business. Frequently, the courts have treated these arrangements as partnerships. Presumably the same treatment should apply to nonspousal joint tenancies (e.g., between father and son) where one tenant's contributions consist largely of services in such a context.
The IRS has stated that the following conditions must exist for a wife's services to be treated as consideration furnished:
1. The services must be in the family business and not be domestic services;
2. There must be an agreement or understanding to share profits; and
3. State law must attribute to the wife half the earnings from the jointly-held property. Again, the same rule should apply to similar arrangements where joint tenancies are held by persons other than husband and wife.
Gift Tax Consequences
The gift tax consequences associated with joint tenancy and tenancy by the entirety interests again depend upon how the joint tenancy is created (e.g., whether the jointly-held property is acquired by gift or inheritance from a third party or whether the co-tenants create the joint tenancy) and whether the joint tenants are husband and wife or other persons.
Joint Tenancy Property Acquired by Gift or Inheritance from a Third Party. If property is acquired jointly by gift, bequest, devise, or inheritance from a third party, there are no gift tax consequences to the new co-tenants whether they are husband and wife or not. Of course, there may be gift tax consequences to the donor under Secs. 2501-2514.
Creation of Joint Tenancies by the Co-Tenants
The gift tax consequences pertaining to the creation of a joint tenancy by the co-tenants depends upon whether they are husband and wife.
Husband and Wife Co-Tenants. No taxable gift results from the creation of joint tenancies by husbands and wives, as a general rule, since the unlimited marital deduction of Sec. 2523 will entirely offset the amount of any gift. No reporting is necessary.
Creation of Joint Tenancies by Persons Who Are Not
Husbands and Wives
In general, the purchase of property jointly, or the transfer of separate property into joint names, is a gift by one of the co-tenants to the extent that one of the new co-tenants does not provide consideration equal to his or her property interest as defined under local law. Exceptions to that rule covering such property as joint bank accounts are separately covered later.
Example 6. Assume that Norton and Bedford acquired land for $100,000 to be held under joint tenancy with the right of survivorship. Each will have a one-half interest under local law. If Norton contributed $80,000 of the original consideration, he has made a gift of $30,000 to Bedford ($50,000 or one-half of the value of the property minus the $20,000 consideration furnished by Bedford).
Exceptions to the General Rule. Bank accounts are an exception to these rules since the creator of a joint account can usually withdraw all of the funds from the account without permission of the other joint tenant. For example, if John put $5,000 into a bank account and listed himself and his daughter Joan as joint tenants, no gift occurs upon the creation of the account. There is no gift unless and until the noncontributing tenant withdraws money from the account without any obligation to the contributing tenant. An exception to the rule on bank accounts is found in the case of bank accounts in states where the local law treats the account as a "true" joint tenancy. There, the gift will occur upon the creation of the joint tenancy.
In the case of joint stock brokerage accounts. Rev. Rul. 69-148 states that such accounts should be treated similarly to joint bank accounts where the securities held in the account are issued in the name of a nominee of the brokerage firm, rather than in the names of the joint tenants. No gift will arise unless or until the noncontributing joint tenant draws on the account without any obligation to the contributing tenant.
Under Reg. 25.2511-1(h) (4), no gift results at the time U.S. savings bonds are purchased and registered jointly, even if one of the tenants furnished all of the consideration. Rather, a gift will take place upon the occurrence of either of the following: 1) the bond is reissued to the noncontributing tenant as sole owner; or 2) the bond is redeemed and the noncontributing tenant keeps some or all of the proceeds.
Example 7. Blake purchased $50,000 of U.S. savings bonds and had them registered in his name and his son's. Later, Blake permitted his son to redeem $20,000 of the bonds and keep the money. At that time Blake made a gift to his son.
Income Tax Consequences
The income tax consequences associated with jointly-held property generally depend upon whether the co-owners are husband and wife. The rules concerning the income tax basis of jointly-held property upon the death of a tenant were covered earlier in the estate tax section of this article.
Joint Tenancy Property Held by Husband and Wife
In general, property held in joint-tenancy by husband and wife does not result in any special tax consequences to the spouses because most couples file joint income tax returns in which all of their income and expenses, gains, and losses are aggregated. Only in the case where the spouses file separate returns are there special consequences--see the following discussion.
Joint Tenancy Property Held by Persons Other Than
Husbands and Wives
In general, income from jointly-held property is taxed in proportion to the income each tenant is entitled to receive pursuant to local law. Gains from the sale or disposition of property are treated similarly. These rules also generally apply to husbands and wives and will have an effect if separate income tax returns are filed.
Note that the rules concerning income on jointly-held property can provide some planning opportunities. That is, property can be placed into joint tenancy with a family member or friend in a lower tax bracket thus reducing overall family taxes. Such strategy would, of course, not work in the case of children under 15, because their unearned income is taxed at the parent's marginal tax rate under Sec. 1 (f).
Special rules apply to the income taxation of interest from joint bank accounts and U.S. savings bonds. As for accounts, a contributing co- owner will be taxed on the interest where the noncontributing tenant's rights do not vest until the contributing tenant's death. On the other hand, if the noncontributing tenant's rights vest immediately, then the income will be taxed proportionally to the co-owners. Practically speaking, the interest is ordinarily taxed to the first tenant who supplies his social security number on the application form. In the case of U.S savings bonds, the interest is taxed to the co-owners in proportion to their contribution toward the purchase of the bonds. Finally, when one joint tenant dies, all of the income from the property goes to the surviving tenants and not to the estate of the deceased tenant.
Expenses and Losses. In general, expenses and losses are allocated to the co-owners the same way as income and gains (i.e., according to the co-owners' shares under local law as long as the co-tenant pays his or her share of such expenses and losses). But, in the case of interest and taxes, co-owners can deduct interest and taxes which they have paid on jointly-held property as long as no other tenant has claimed a deduction from such items.
Terminations of Joint Tenancies
In some cases, husbands and wives and other tenants may desire to terminate their joint tenancy ownership of property in response to the estate and gift tax consequences covered earlier and/or the nontax disadvantages that will be covered later.
Where husbands and wives terminate joint tenancies, no gift tax consequence should result due to the unlimited marital deduction of Sec. 2523. If joint tenancy property is split up in connection with a divorce, no taxable gift will result if transfers are made: . Pursuant to a written agreement relative to the marital and property rights of the spouses, provided the conditions of Sec. 2516 are met; . To provide support of an ex-spouse and minor children; or . Pursuant to a court order.
In the case of terminations of nonspousal joint tenancies, no gift will result where the property interests are split according to the co- owner's proportional interests under local law. This presumably includes a conversion of a joint tenancy into a tenancy in common where the co-owners' relative interests remain the same as in the joint tenancy ownership.
A final consideration is the nontax disadvantages associated with joint tenancy ownership.
Probate will usually not be avoidable once the last surviving tenant holds the property. Joint tenancy ownership, thus, cannot cause the avoidance of probate permanently.
More importantly, the use of joint tenancy ownership may ultimately cause property to end up in the ownership of persons other than those who the creator would like to see get the property. That is because the creator cannot control the postdeath disposition of the jointly-held property. The property automatically passes to the surviving tenant regardless of provisions in the deceased tenant's will. Once the property is in the hands of the surviving tenant, almost anything can happen. A decedent's property held in joint tenancy with her husband may end up eventually passing to persons other than the decedent's children if the husband remarries and places the property into joint tenancy with a new spouse.
Example 8. Ken and Barbara Davies hold all of their real estate in joint tenancy. Ken dies, and Barbara remarries a year later, putting the property into joint tenancy with her new husband. Thereafter, Barbara dies. At that time, the property passes to the new husband who can do with it as he chooses. Ken and Barbara's children may be left out in the cold.
Jointly-held property may be particularly vulnerable to loss in the case of divorce. Frequently, the spouse who makes less money will come out better from the divorce if the property is jointly-held. Thus, the higher earning spouse who places property into joint ownership with the other spouse can end up receiving the short end of the stick. The spouse who earns more or inherits property will probably fare better in a divorce if he or she holds the property separately.
Finally, if property is held jointly, the flexibility of the contributing co-owner to sell the property in order to borrow on it is considerably reduced. And if the jointly-held property is a bank account or another monetary asset that can be withdrawn by a noncontributory, the contributing tenant can lose the property through no action on his or her part.
Property is often held in joint tenancy ownership (especially by married couples) because it is easy to set up, convenient, avoids probate and the difficulties of passing title to property at death of one of the tenants. However, spouses and others should consider the potentially adverse gift and estate tax consequences associated with joint tenancy ownership as well as significant nontax disadvantages. The creator of a joint tenancy loses control over the ultimate disposition of the joint tenancy property after his or her death. These factors should be carefully evaluated before joint tenancies are created; in some cases, existing joint tenancy ownerships probably should be terminated.
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