The problem with federal estate and gift tax rules governing joint tenancies with a noncitizen spouse is that their complexity is way out of proportion to the frequency with which most practitioners confront them. (Throughout this article, the term “joint tenancy” is used to denote a joint tenancy or a tenancy by the entirety with a right of survivorship.) These rules feature the resurrection of “principles” of repealed Code sections, whose numbers have already been reassigned to new unrelated rules—sort of like regulatory hide and seek. There are different rules for real property and personal property. And different rules depending on when the joint tenancy was created and when the joint tenancy is terminated.
Most trust and estate attorneys do not deal with the joint tenancy rules for noncitizen spouses on a regular enough basis to keep the esoteric properties of these rules readily accessible when needed. Although the structure and terminology of these rules seem impenetrable when first encountering them, they can be comprehended with the aid of a few basic principles and an understanding of some estate and gift tax history. This article aims to extract key conceptual guidelines from these rules in order to quickly orient the practitioner for those occasions when he or she needs to understand how they change the estate and gift tax consequences of transfers between spouses.
Basic Principles and Historic Background
The first and most basic principle is that U.S. gift and estate tax laws apply to all property of U.S. citizens and U.S. residents, wherever that property is located worldwide, and to the U.S. situs property of noncitizen nonresidents. Special rules apply whenever such property is transferred to a spouse who is not a citizen, and it is the citizenship of the donee spouse that changes the regular rules. The estate lawyer needs to identify the citizenship of both spouses involved in any gratuitous property transfer, whether pursuant to estate administration or estate planning, early in the representation. If the donee spouse is not a U.S. citizen, the lawyer must know how these special rules require adjustments in the normal way of doing business.
Two conflicting public policy goals led to these seemingly incomprehensible rules. First, before the unlimited marital deduction against estate and gift taxes was enacted in the Economic Recovery Tax Act of 1981 (ERTA), 97 Pub. L. No. 34, 95 Stat. 172, Congress wanted to prevent gift tax consequences when a married couple, pursuing the American dream, purchased a home and titled it in joint tenancy. Before ERTA, Code § 2515 provided that creation of a joint tenancy in real property was not deemed to be a transfer for gift tax purposes and deferred any gift tax consequences until termination of the joint tenancy. The key thing to remember about Code § 2515 is that its purpose was to prevent a taxable gift when spouses purchased a home. Congress did not extend its concern to the creation of joint tenancies between spouses in personal property. When Congress enacted the unlimited marital deduction in 1981, it logically concluded that Code § 2515 had served its purpose and repealed it. Code § 2515 was subsequently reassigned to new unrelated rules.
ERTA’s unlimited marital deduction, which originally was available to any spousal transfer regardless of the donee spouse’s citizenship, led to a new concern in Congress known to some as the “war bride” phenomenon. There must have been a few really egregious cases of cheeky widows of U.S. servicemen, who never became U.S. citizens and then, upon their husbands’ deaths, promptly returned to their native country, forever depriving the United States of the ability to tax their husbands’ estates. The author only imagines these cases because there is little or no documentation of this phenomenon. Nevertheless, in the Technical and Miscellaneous Revenue Act of 1988 (TMRA), 100 Pub. L. No. 647, 102 Stat. 3342, Congress repealed the estate tax marital deduction for decedents dying after November 10, 1988, if the surviving spouse is not a U.S. citizen, and it repealed the gift tax marital deduction for lifetime transfers to a noncitizen spouse.
To avoid seeming too harsh on these folks, Congress softened the blow with the qualified domestic trust, the superannual gift tax exclusion, and some very complex rules limiting the impact of the new law to transfers made after its effective date. Congress apparently also realized that denial of the gift tax marital deduction would catch noncitizen spouses in the very trap repealed Code § 2515 was intended to address. Without the marital deduction, noncitizen spouses pursuing the American dream of home ownership might find themselves unintentionally and unknowingly receiving a taxable gift. To address this concern, Congress resurrected “the principles of sections 2515 and 2515A (as such sections were in effect before their repeal by [ERTA]) . . . except that the provisions of such section 2515 providing for an election shall not apply.” Code § 2523(i)(3). The IRS issued regulations to clarify application of these principles in 1995, but unfortunately they are not nearly clear enough to practitioners who have to deal with them on an infrequent basis.
To illustrate the estate and gift tax rules applicable to joint tenancies with a noncitizen spouse, this article will present a fairly simple fact situation and then look at the rules that affect that situation in two scenarios. The first scenario looks at estate inclusion rules when one of the spouses dies during the joint tenancy. The second scenario looks at gift tax rules when the spouses terminate the joint tenancy during their lives, to avoid the problems of the first scenario and to equalize their estates for estate planning purposes.
Here are the facts: husband and wife, both U.S. residents of a noncommunity property state and nearing the age of 80, have accumulated $2 million worth of property during their 50 years of marriage. Husband is a U.S. citizen and wife is not a U.S. citizen. Wife considered becoming a citizen later in life but felt the process was too much of a hassle at her age. Wife also believes that if she is widowed, she may return to her native country, where the aged receive better care. Husband and wife titled all of their property, at the time it was acquired, as joint tenants with a right of survivorship. All the property was purchased with funds produced by husband’s employment. The property includes marketable securities acquired during the years 1955–86 through husband’s employee purchase plan, currently valued at $750,000, and a home purchased in 1974, currently valued at $1 million.
Scenario 1: Estate Tax Treatment of Joint Tenancy Property in the Estate of the First Spouse to Die
Assuming husband and wife leave their property in joint tenancy, and husband dies first, the amount that will be included in husband’s gross estate for federal estate tax purposes is governed by the contribution rule. This is the general rule of Code § 2040(a), which provides that the entire value of a decedent’s joint tenancy property is included in the taxable estate except the proportion that can be shown to be attributable to consideration furnished by a surviving joint tenant or a surviving joint tenant’s share of a gift made to the decedent and the surviving joint tenant by a third person.
Code § 2040(b) creates an exception to the general contribution rule where the joint tenants are husband and wife. This exception for a “qualified joint interest,” effective for estates of decedents dying after 1981, provides that only one-half of the value of the joint tenancy property is included in the deceased spouse’s taxable estate, regardless of contribution by either spouse. In 1988, however, as part of TMRA’s no-more-marital-deduction “crack down” on noncitizen spouses, Congress reinstated the general contribution rule of Code § 2040(a) for inclusion of the decedent’s joint tenancy property when the surviving spouse is not a U.S. citizen. Code § 2056(d)(1)(B).
Under the contribution rule, if the husband in our example dies first, the full value of the couple’s joint tenancy property would be subject to estate tax in his estate. Although property ownership transfers to the wife by virtue of her right of survivorship, no marital deduction is available against this tax. If the wife remains a U.S. resident and does not obtain citizenship, the full value of the property will be included again in the wife’s taxable estate.
The rules provide several forms of post-mortem relief in this situation. First, the qualified domestic trust provisions of the Code allow transfers to the surviving spouse that take place outside of the decedent’s estate, such as by right of survivorship, to qualify for the marital deduction, if the spouse transfers the property to a qualified domestic trust before the deadline for the decedent’s federal estate tax return. Code § 2056(d)(2)(B). The surviving spouse can create a qualified domestic trust for this purpose . Treas. Reg. § 2056A-4(b)(1). Nevertheless, the lawyer who has an opportunity to plan the estate before the first death may find that clients wish to avoid the administrative complexity and cost of a qualified domestic trust, and, depending on the size of the estate, the qualified domestic trust may be entirely avoidable.
There also is relief in the form of a tax credit in the survivor’s estate for any federal estate tax paid because of the inclusion of joint tenancy property in the estate of the first spouse to die, when such property is also included in the taxable estate of the surviving noncitizen spouse. The tax credit is available for the tax paid, regardless of the passage of time between the two deaths. This credit is only for estate tax paid, however, and does not account for waste of the first spouse’s unified credit expended by inclusion of the joint tenancy property in the first estate, or for the “grossing up” of either or both estates to a higher estate tax bracket because of inclusion of the entire value of the property in both estates.
A very complex form of post-mortem relief provides a segue into the murkier territory laid out by the gift tax rules. Treas. Reg. § 20.2056A-8(a)(2) provides that when the contribution rule is applied to determine the amount of consideration furnished by a noncitizen surviving spouse, any consideration provided by the deceased spouse before July 14, 1988, will be attributed to the surviving spouse, to the extent that the gift tax rules in effect at creation of the joint tenancy resulted in a completed gift to the surviving spouse. If creation of the joint tenancy was treated by the tax rules as a taxable gift, only the value of the joint tenancy property that these rules treated as having been retained by the donor spouse will be included in donor spouse’s taxable estate. If creation of the joint tenancy was not treated as a taxable gift, the contribution rule may result in inclusion of the full value of the property in both spouses’ estates.
This last form of relief requires the estate attorney to review federal gift tax treatment effective at the time the joint tenancies were created. In our example, an understanding of these rules would allow the estate lawyer to prevent inclusion of one-half of the value of the couple’s personal property in husband’s estate. Estate planning lawyers who have the opportunity to review the estate before the first death will also need to review these historical gift tax treatments to determine whether a taxable gift will occur if the spousal joint tenancy is terminated before the first death.
Scenario 2: Gift Tax Treatment on Termination of Joint Tenancy with a Noncitizen Spouse
Step A: Analyzing Gift Tax Treatment on Creation of the Joint Tenancy.
The gift tax treatment of termination of a joint tenancy with a noncitizen spouse depends upon how the gift tax rules treated creation of that joint tenancy, so those rules must be reviewed first. The general contribution rule has always applied to the creation of a joint tenancy in personal property. Under the general gift tax principle of Treas. Reg. § 25.2511-1(h)(5), when one party with his or her own funds purchases any type of property and has title conveyed to him- or herself and another as joint owners with rights of survivorship, and either party may sever his or her interest, there is a gift to the party who did not provide any consideration. The amount of the gift is half of the value of the property. If the parties are spouses, the marital deduction and/or annual exclusion may or may not prevent a gift tax, depending on the amount of the gift and the citizenship of the donee spouse.
With real property the general principle of Code § 2511 has been modified during certain time periods by the application of Code § 2515. This is the section that prevented gift tax consequences when a married couple purchased a home and titled it in joint tenancy before 1981. In TMRA (1988), Congress resurrected the principles of Code § 2515 to fix the problem of an unexpected taxable gift when spouses create a joint tenancy in real property but lack an unlimited marital deduction because one or both is not a U.S. citizen. With a home purchase, even the superannual gift tax exclusion may not be large enough to prevent a taxable gift.
Some confusion arises from TMRA’s concurrent resurrection of the principles of Code § 2515A. This latter Code section simply provides that creation of a spousal joint tenancy in personal property results in each spouse retaining a one-half interest in the property. This principle avoids the need to compute the spouses’ relative actuarial probability of enjoying the right of survivorship. Unlike Code § 2515, § 2515A contains no principle for deferring gift tax consequences on creation of a joint tenancy in personal property.
The key thing for the estate planning lawyer to remember, as he or she reviews the rules in place at the creation of a joint tenancy between spouses, is that during periods of application of Code §§ 2515 and 2515A or their principles, § 2515 allows a taxpayer to defer the gift tax consequences of creation of a joint tenancy in real property only. Thus, regardless of when a spousal joint tenancy in personal property was or is created, creation results in a taxable gift to the extent that one spouse provides consideration that exceeds the value of the right retained by that spouse. One must look to the marital deduction and annual exclusion in effect at the time of creation to determine the actual gift tax consequences.
For real property, the waters have been muddied by the policy goals of Code § 2515. The general contribution rule also applies to gift tax treatment of creation of a spousal joint tenancy in real property, except during time periods when the rules apply Code § 2515 or its principles to defer a taxable gift until termination of the joint tenancy. Here is a rough and ready guide to those time periods:
• Pre-1955: Contribution Rule. The general contribution rule applied to the creation of a spousal joint tenancy in real property up until this point.
• 1955 Through 1981: Creation Not Deemed a Transfer. During the years from 1955 up until passage of ERTA in 1981, Code § 2515 provided that creation of a spousal joint tenancy in real property was not deemed a transfer of property for gift tax purposes, regardless of the proportion of the total consideration furnished by either spouse, unless the donor spouse elected to treat it as a gift on a gift tax return. Termination of such a tenancy, however, was deemed to be a gift (see following section).
• 1982–Present for Spousal Joint Tenancy with U.S. Citizen Spouse; 1982–88 for Spousal Joint Tenancy with a Noncitizen Spouse: Contribution Rule. After ERTA, creation of a spousal joint tenancy in real property required no special rule to avoid gift tax consequences because of the unlimited marital deduction. ERTA made no distinction between a citizen and noncitizen spouse with respect to the marital deduction. Hence, spousal joint tenancies in real property created during this period are treated under the general contribution rules, and the unlimited marital deduction eliminates any gift tax consequences of transfers to a spouse, regardless of citizenship.
• Rule After 1988 for Spousal Joint Tenancy in Real Property with a Noncitizen Spouse: Creation Not Deemed a Transfer. TMRA made the unlimited marital deduction against federal gift tax unavailable for transfers to a noncitizen spouse. Relief from this rule was provided in the form of the super-annual exclusion and the resurrection of Code § 2515 principles.
Please consult the regulations for the precise dates of application.
Step B : Analyzing Gift Tax Treatment of Termination of the Joint Tenancy. Knowledge of the gift tax treatment of termination of a joint tenancy with a noncitizen spouse is vital to estate plans that require such terminations to fully use the applicable exemption amount of the first spouse to die. The regulations specifically state that conveyance of property from the spouses as joint tenants to tenants in common is deemed a termination of the joint tenancy. Treas. Reg. § 25.2515-1(d). A general rule of termination is that if the contribution rule was not applied at the creation of the joint tenancy, because creation was not deemed to be a transfer, the contribution rule will be applied at termination of the joint tenancy. Regardless of the gift tax treatment at the creation of the joint tenancy, however, a gift can occur on termination depending upon what each spouse receives from the termination. If creation was not deemed to be a taxable transfer, a gift will occur on termination if a spouse receives proceeds from termination out of proportion to the consideration that the spouse contributed at the creation of the joint tenancy. If creation of the joint tenancy was treated as a taxable transfer, a gift still can occur at termination if a spouse receives proceeds out of proportion to the interest the spouse surrenders at termination.
Because creation of a joint tenancy in personal property with a noncitizen spouse is and always has been treated by the gift tax rules as a taxable transfer, the effect of relative contribution between the spouses is fixed at creation, and determination of the amount of any gift at termination would be made by application of the general principles set forth in Code § 2511 and its regulations. That is, if a spouse receives an interest in the proceeds of termination out of proportion to the interest that the spouse surrendered by termination, a gift has occurred. Applying the one-half retained interest principle to the creation of the joint tenancy, no gift would occur upon termination of the tenancy as long as each spouse receives one-half of the proceeds of the termination.
Regardless of when a spousal joint tenancy in real property was created, if the rules did not treat creation of the tenancy as a gift (i.e., Code § 2515 or its principles were effective) and any available election to treat it as a gift was not exercised, termination always results in a gift by the spouse who receives a smaller share of the proceeds than that attributable to the total consideration furnished by that spouse. No reduction in the value of the gift may be made by virtue of annual exclusion amounts (for example, as one spouse made mortgage payments over the years), unless such gifts were disclosed on gift tax returns. Treas. Reg. § 25.2515-3(b).
When creation of the tenancy in real property is treated as a gift, Treas. Reg. § 25.2523(i)-2(b)(2)(ii) technically still applies the contribution rule at termination; however, it amends that rule by providing that if a gift occurred on creation, the amount treated as a gift on creation is treated at termination as consideration provided by the donee noncitizen spouse. Thus, as with termination of a joint tenancy in personal property with a noncitizen spouse, the effect of relative contribution between the spouses is fixed at creation, and a gift will not occur upon termination of the tenancy unless a spouse receives an interest in the proceeds of termination out of proportion to the interest that spouse surrendered by termination.
In the example introduced at the beginning of this guide, the estate planning attorney who enters the scene before the first death should terminate the joint tenancy in the clients’ corporate stock as soon as possible, splitting the stock between two equal accounts in the name of each spouse. Creation of the joint tenancies in the stock was treated as a taxable transfer and, having occurred gradually over time based on husband’s annual earnings, was most likely covered by the annual gift tax exemption or limited marital deduction in effect at the time. A gift will not occur upon termination as long as each spouse receives one-half of the proceeds of termination. Half of the value of the stock will receive a step-up in basis and will be available to fund a credit shelter bypass trust at the first death, regardless of which spouse dies first. Joint tenancy in other personal property assets also may be terminated as is practical to maximize funding of the bypass trust. With maximum funding of the bypass trust, the administrative cost of a qualified domestic trust may be avoidable.
Creation of the joint tenancy in the clients’ home in 1974 was not deemed a transfer by virtue of Code § 2515, so gifts created on termination of that joint tenancy must fall within the superannual exclusion amount. Fractional interest deeds can convey the superannual exclusion amount to the noncitizen donee spouse on an annual basis. The complexity of this should be weighed against the clients’ tolerances, the bypass trust funding available after all personal property joint tenancies have been terminated, and issues related to joint ownership of the home between the surviving spouse and the bypass trust. Keep in mind that one appraisal can support two fractional deed transfers, one in late December and one in early January of the next year.
This guide provides basic conceptual principles to help the practitioner navigate through the complex estate and gift tax rules governing joint tenancy with a noncitizen spouse. The rules themselves contain additional nuances and cover many fact situations that have not been discussed here. Perhaps this roadmap will keep the practitioner from getting lost in the details of those rules during the relatively infrequent occasions when he or she must comprehend how they change the estate and gift tax consequences of transfers between spouses.
Miriam A. Goodman is an attorney with Frascona, Joiner, Goodman & Greenstein, in Boulder, Colorado.