Probate & Property Magazine
Obtaining a Full Step-up in Basis for Jointly Held Property Between Spouses
By William P. LaPiana and Marc S. Bekerman
William P. LaPiana is the Rita and Joseph Solomon Professor of Wills, Trusts, and Estates at New York Law School and a contributing editor to “Keeping Current—Probate.” Marc S. Bekerman practices law in New York City and on Long Island, is Associate Director and Adjunct Professor of Law in the Graduate Tax Program of New York Law School, and is a member of the Section Council.
Holding property together as joint tenants with right of survivorship has numerous advantages to spouses. Among the advantages are asset protection, disability planning, and possible avoidance of a probate or administration proceeding on the death of the first spouse. Because most assets can be held in this manner, many married couples own a substantial portion of their property in this form. This article will review a possible additional advantage that may be available to a surviving spouse of jointly owned property in jurisdictions that have favorable law and when proper planning is done both before and after the death of the first spouse.
Tax Consequences of Jointly Held Interests
The estate tax treatment of jointly held interests is governed by section 2040 of the Internal Revenue Code (“Code”). The general estate tax treatment for property interests held jointly by spouses, usually referred to as qualified joint interests, is that each spouse is treated as having owned a one-half interest in the assets at the time of the first spouse’s death (that is, contributions between spouses are not traced for estate tax purposes). Code § 2040(a). As a result, the estate of the first spouse to die will include one-half of these qualified joint interests and will report such holdings on Schedule E(1) of the federal estate tax return (assuming that a return is required to be filed). The inclusion of these assets for estate tax purposes will not increase the estate’s potential estate tax liability because the qualified joint interests will qualify for the marital deduction as passing to the surviving spouse by operation of law. Code § 2056. (Assume that both spouses are U.S. citizens for purpose of this article.)
The income tax treatment of the qualified joint interests in the hands of the surviving spouse is also fairly simple in most cases. At the death of the first spouse to die, the surviving spouse will not recognize income on receipt of these assets. Code § 102. In addition, the basis of the qualified joint interests will be adjusted to the fair market value of the property at the time of death to the extent that such interests are included in the estate of the deceased spouse for estate tax purposes. (Assume for purposes of this article that no elections are made regarding potential alternate valuations of assets.) Code
Only the one-half portion of the qualified joint interest included in the gross estate under Code § 2040 will receive a basis adjustment under Code § 1014. There will be no adjustment to the basis of the other one-half of the qualified joint interest.
Example—H and W own their residence as tenants by the entirety. Their basis in the residence is $100,000. At the time of H’s death, the fair market value of the residence was $400,000. Even if no estate tax return is required to be filed, W’s basis in the residence will be $250,000 (one-half at the original basis of $100,000 divided by 2 and one-half at the fair market value of $400,000 divided by 2).
For joint tenancies created by spouses before 1977, there is an interesting twist on the general rule set forth in Code § 2040(a). In Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992), the Sixth Circuit held that such joint interests are governed by the contribution tracing rule in effect before the passage of the Economic Recovery Tax Act (ERTA) in 1981 and still in effect for joint tenancies involving other than married couples. Inclusion of the jointly held property in the estate of the spouse first to die, therefore, is determined by which spouse contributed how much of the consideration for the acquisition of the jointly held property. Although the IRS did not accept the result in Gallenstein, in 2001 it conceded the point by acquiescing in the result in Hahn v. Commissioner, 110 T.C. 140 (1998), which followed Gallenstein. Therefore, joint interests created by spouses before 1977 are taxed on the death of the first spouse under the rules of Code § 2040(b).
Code § 2040(b) creates a rebuttable presumption that the first owner to die contributed 100% to the acquisition of the joint property and that the entire property is includable in that owner’s gross estate. To rebut the presumption, a tracing rule is available to taxpayers who can demonstrate that the surviving joint tenant contributed to the acquisition of the property, which allows for an allocation of the property between the two joint tenants based on their respective contributions.
In many cases this rule is to the government’s advantage in that it maximizes the value of the estate of the first owner to die, while placing the burden of challenging the default rule on the surviving joint tenant, who may be unable to provide sufficient proof to rebut the presumption. Further, assuming that the surviving joint tenant lives more than two years, the property will be at least partially taxable in that survivor’s estate. See Code § 2013 (Credit for Tax on Prior Transfers). If the property passes to a surviving spouse, however, the marital deduction will completely offset the increased value, resulting in no additional estate tax liability.
As the entire property passes through the estate of the first spouse to die under Gallenstein, Code § 1014 mandates a corresponding effect on the basis adjustment. Specifically, the entire interest in the property will receive a basis adjustment to fair market value because the entire interest was included in the estate of the first spouse to die. Code § 1014.
Example—Assume that the residence in the prior example was purchased in 1970. Because the Gallenstein rule applies, the entire residence will be included in H’s estate for estate tax purposes and W would take a basis of $400,000 (the fair market value of the entire property at the time of H’s death). The entire $400,000 reportable on the estate tax return, however, will also generate a marital deduction of $400,000, resulting in no estate tax liability on account of this asset.
One important note is that the Gallenstein rule applies whether or not an estate tax return is required to be filed. This is especially important given the increasing applicable exemption amount. The surviving spouse, therefore, should be made aware of the new, properly computed, basis in the formerly jointly held property. In addition, if an estate tax return is required to be filed for an estate when the taxpayer has determined that Gallenstein applies, it is appropriate usually to include the asset on Schedule E(2) of the estate tax returns because the joint interest is not a qualified joint interest under Code § 2040.
As one can imagine, a full step-up in basis with no additional estate tax liability is a highly desirable result because it will reduce the potential capital gains on the sale of the property by the surviving spouse. Further, if the property in question is depreciable (such as rental real estate), the increased basis will also increase the income tax deductions available to the surviving spouse on an annual basis. (Because of the extremely favorable tax treatment, estate planners should take care when considering the severance of a joint tenancy that would qualify for a full step-up in basis under Gallenstein.) Although this result cannot be obtained under Gallenstein if the joint tenancy was created after 1976, one question is whether the result can be replicated with proper planning. The authors propose that, with proper planning under fairly ordinary circumstances, it is possible to replicate the Gallenstein result in the majority of jurisdictions.
Use of Disclaimers for Jointly Held Property Interests
At the end of 1997, the Treasury promulgated new regulations under Code § 2518 governing disclaimers of jointly held property by surviving joint holders. These new regulations settled the questions surrounding such disclaimers in a way favorable to taxpayers. In short, beginning in 1998 surviving joint tenants with the right of survivorship and tenants by the entirety in property other than bank, brokerage, and other investment accounts can disclaim that portion of the jointly held property to which they succeed. In the case of joint tenancies between spouses and tenancies by the entirety involving other than bank, brokerage, and investment accounts, the surviving spouse can disclaim one-half of the property regardless of (1) the proportion of the consideration for the acquisition of the property furnished by the surviving spouse, (2) the portion of the property included in the decedent’s gross estate under Code § 2040, and (3) whether or not the interest could be unilaterally severed under local law. Treas. Reg.
Example—W has significantly more resources than H. W acquires real property solely with her funds and takes title with H as joint tenants with right of survivorship or tenants by the entirety. At W’s death, H can make a qualified disclaimer of one-half of the real property. (The rules governing disclaimers are contained in Code § 2518 and applicable state law. For purposes of this article, it is assumed that any disclaimer is properly executed under both federal and state law and that disclaimers of jointly held property are possible under state law.)
In this example, if H does not execute a disclaimer, H will receive the property with a one-half step-up in basis under Code § 2040(a). The disclaimer will not change that outcome, however, because the result of the disclaimer is that one-half of the property passes through W’s probate estate. That one-half of the property will receive a new basis, but in the right circumstances (and perhaps with a further disclaimer by H) the property will pass to someone other than H, not qualify for the marital deduction, and use up part of the applicable exclusion amount that might otherwise be wasted. Indeed, most would assume that qualified disclaimers of jointly held property by a surviving spouse are usually made to mitigate overqualification of the marital deduction.
Obtaining the result of Gallenstein for some joint property arrangements created after 1977 is possible because of the special rule for disclaimers of joint bank, brokerage, and other investment accounts. Treas. Reg.
Example—W has significantly more resources than H. W opens a brokerage account and deposits in the account her own funds, which then are used to purchase various securities. While H and W are both alive, W can regain sole ownership of the account without H’s consent. At W’s death, H may make a qualified disclaimer of the entire account.
In this example, if H does not execute a disclaimer, H will receive the property with a one-half step-up in basis under Code § 2040(a). But if H is the residuary beneficiary under W’s will and there are sufficient other assets to pay all expenses and pre-residuary legacies, H’s disclaimer will allow the entire property interest to pass to the estate and then to H as the residuary beneficiary. (Although H receives the disclaimed property as a result of the disclaimer, the disclaimer is qualified for
If state law allows for disclaimers of a jointly held property interest by a surviving spouse in accordance with his or her contributions to the property, a significant planning opportunity for jointly held financial assets may be available regardless of the size of the estate or when the joint interest was created.