The Curious Case of the Persistent Step-Up:In Which the Mysterious Basis Rules Concerning Joint Tenancies and Life Estates are Unveiled and Explicated
I. A LEGAL MYTH
Few legal myths are as persistent as the idea that the gratuitous transfer of a joint or remainder interest in property will cause the loss of the basis step-up on the death of the transferor. This piece of disinformation is pernicious because it is a selling point for trust mills pushing expensive estate planning kits and questionable investments. Many attorneys are confused about this and advise clients to use unnecessarily complex estate plans, solely to preserve the step-up in basis on death. This article is a primer on estate planning using joint tenancies and life estates, emphasizing the effect on tax basis of passing property through will substitutes.
Retention of a joint interest, a life estate, or even a beneficial use will cause property to be included in the gross estate for estate tax, triggering a basis step-up on the death of the original owner. The principles are not new, but a concise and understandable treatment of the basis rules is difficult to find. To decipher the basis rules in most treatises it is necessary to consult several chapters to come to an understanding of when property gets a full step-up. Furthermore, repeal of the estate tax may make a major change in the treatment of life estates.
The fact pattern is usually quite simple: a client wants to confer ownership of a piece of property effective on his or her death. After introducing a typical small-estate planning situation, the various rules governing tax basis will be discussed.
II. THE GUNN CASE
My client, Benjamin Gunn, a former entrepreneur in marine acquisitions, has an estate in which a quit claim deed and a transfer on death designation may provide a satisfactory estate plan. Despite early successes, his net worth had declined due to imprudent ingestments of liquid assets at The Admiral Benbow and several spectacularly unsuccessful connubial ventures. He is living on Social Security and his assets consist of his home and 1,000 shares of stock in a successor corporation to The East India Company. The home and the stock have very low tax basis. He wants his nephew, James Hawkins, to receive the home and his stock on his death. A major estate-planning goal for Mr. Gunn is the avoidance of taxes.
III. ESTATE PLANNING ALTERNATIVES
The alternatives I discussed with Mr. Gunn were to use a will to pass the property, to create a revocable living trust funded with the property, or to use transfer on death designations and a quit claim deed so that the property would transfer immediately on death. Relying on a will would require that his estate be probated. Creating a trust would avoid probate, but the cost up front would be as much as the expense of probating the estate on his death. He did not want his property to pass through probate nor did he want it to be subject to capital gains tax.
Considering these various alternatives–expense being the primary consideration–Mr. Gunn decided to make Mr. Hawkins a joint tenant in his home and on the stock. This would prevent him from selling them without Mr. Hawkins’ agreement, but he trusted Mr. Hawkins, who had often proven his honesty and loyalty. Mr. Gunn was to come back a fortnight hence to execute the deed and transfer the stock.
Two days later he called because he had read on the Internet that making Mr. Hawkins a joint tenant would subject the property to capital gains tax after his death. He called me a poltroon and a gutter-dwelling caitiff: passing myself off as a lawyer when I don’t know the difference between a tariff and a traffic jam. He finally wound down and agreed to let me explain why the article was incorrect.
IV. CONCERN ABOUT BASIS
Mr. Gunn’s concern was that his property would not have a tax basis equal to fair market value when Mr. Hawkins would receive it. Capital gain or loss is calculated from “tax basis,” which would be Mr. Gunn’s purchase price with certain adjustments. If Mr. Hawkins’ basis in the home–call it Blackacre–or the stock rose to its fair market value in Mr. Gunn’s death, Mr. Hawkins could avoid capital gains tax on sale within six months. This increase in basis is called a “step-up.”
In the absence of a basis step-up, Mr. Hawkins would receive “carry-over” basis–Mr. Gunn’s basis. Capital gains tax would be imposed on the difference between Mr. Gunn’s basis and a higher selling price. Appreciated assets received by gift generally have carry-over basis, but property acquired by “reason of the death” acquires basis equal to the fair market value as of the date of death or alternate valuation date. 1
The basis step-up is triggered by rules found in the Estate and Gift Tax portion of the Internal Revenue Code, not the Income Tax portion. This is important because the basis rules were written to ensure that property did not escape Estate Tax. It was acceptable to Congress to benefit lower-income taxpayers so that more property could be drawn into the gross estate for Estate Tax calculations. Since the rate imposed under the Estate Tax was higher than the tax on capital gains, Congress wrote the rules to bring as much of the decedent’s property as possible into the gross estate, without regard to any income-tax side effects.
Assets in the decedent’s gross estate for estate tax purposes are “acquired by reason of death.” 2 Thus, counting the property for estate taxes–a serious disadvantage for a large estate–will benefit inheritors from small estates. Inclusion steps up the tax basis. Tax planners who do not understand the connection between the basis step-up and the estate tax will see the basis step-up rules as an incredible income tax loophole. They will assume that the Internal Revenue Code could never be that generous, but they are looking into the wrong end of the telescope.
Like all good urban legends, the myth that a joint tenancy prevents a full basis step-up grows out of a seed of truth and sounds reasonable. The kernel of truth pertains to joint tenancy between spouses, also known as tenancy-by-entireties. After enactment of the Economic Recovery Tax Act of 1981, if a husband and wife are the only joint tenants in a piece of property, the property receives a 50% step-up in basis on the death of either spouse. 3
V. BASIS FOR SURVIVING SPOUSE
To illustrate the surviving spouse rules, consider Dana and Shannon, who are married. Dana purchased Whiteacre out of her own money for $10,000 in 1985, but took title jointly with Shannon. In 2005, when Dana died, the property was worth $100,000. In Shannon’s hands, Whiteacre now has a tax basis of $55,000. 4 The result would be the same if Shannon died, with Dana as the survivor. Although there are exceptions, this is the general rule for married couples.
The discussion of basis step-up between spouses is a digression from the situation of Mr. Gunn, whose most recent matrimony was terminated several years ago. But it is necessary to comprehend the situation where a spouse is involved to understand why there is such a widespread misunderstanding of the basis rules.
It being generally true that when one spouse dies only half of entireties property gets a step-up in basis, one tends to reason by extension that the same rule applies to all joint tenancies. Fortunately for gratuitous joint tenants who are not married to their donor joint tenants, the rule does not apply.
The transfer of Mr. Hawkins’ joint interest will be gratuitous. After the execution of the new deed, Mr. Gunn and Mr. Hawkins will each own an undivided interest in Blackacre. A superficial reading of IRC §§ 2033 & 2040 would lead one to believe that on Mr. Gunn’s death only his portion of Blackacre would receive a step-up in basis.
VI. IRC §§ 2033 & 2040 AND JOINT TENANCY
IRC § 2033 provides, “The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.” 5 The interest of Mr. Gunn in Blackacre would seem to be limited to his interest as a joint tenant.
IRC § 2040 reinforces this appearance. It states, in part:
The value of the gross estate shall include the value of all property to the extent of the interest therein held as joint tenants . . . except such part thereof as may be shown to have originally belonged to such other person and never to have been received or acquired by the latter from the decedent for less than an adequate and full consideration. . .6
The phrase “to the extent of the interest therein” limits the inclusion in the gross estate–and consequently the basis step-up–to the portion owned by the decedent. This would cover the situation if Mr. Gunn made Mr. Hawkins a joint tenant by gift and Mr. Hawkins died. Whether there is a step-up when the decedent is the original owner–Mr. Gunn in this case–is answered by the next subparagraph. This states:
Provided, That where such property or any part thereof, or part of the consideration with which such property was acquired, is shown to have been at any time acquired by such other person from the decedent for less than an adequate and full consideration in money or money's worth, there shall be excepted only such part of the value of such property as is proportionate to the consideration furnished by such other person. . .7
Property that is “excepted” is property excluded from the gross estate and “only” the property that the joint tenant acquired for fair consideration is excepted. Therefore, the interest of a joint tenant is included in the decedent’s gross estate unless he or she paid full consideration for that interest. Inclusion results in a step-up in basis for both personal and real property.
Whoever wrote the article that Mr. Gunn read might be surprised to learn of this seeming loophole in the tax law. It would shock the author to learn that life estates and even use of property can cause a step-up in basis.
VII. IRC § 2036 AND BENEFICIAL USE
Mr. Gunn might have conveyed Blackacre to Mr. Hawkins for no consideration, reserving a life estate. He might also have transferred the property but lived there until death. The property would be included in Mr. Gunn’s estate either way. Internal Revenue Code § 2036 8 provides that “the gross estate shall include the value of all property” in which the decedent retained for life or “for any period which does not in fact end before his death . . . the possession or enjoyment of, or the right to the income from, the property” or “the right . . . to designate the persons who shall possess or enjoy the property.” 9
However, there is a possible problem with life estates after 2009. After termination of the Estate Tax, the basis of assets acquired from a decedent after 2009 may be increased by $1.3 million plus $3 million for a spouse. But the termination of a life estate by the death of the life tenant is not considered "acquired" from a decedent under new IRC § 1022.10 Thus, there may be no basis step-up. Similarly, property in which the decedent retained a general power of appointment is not considered acquired from a decedent and may not receive the basis step-up under the new law. At this point the matter is in doubt.
It is likely that the omission of life estates from the basis step-up rules will be corrected by December 31, 2009 because Congress would not want to play a “gotcha” on the hundreds of thousands of taxpayers receiving property subject to a life estate, not expecting to pay capital gains tax. However, this should receive careful review by estate planning attorneys in the run-up to 2010.
VIII. CONTROL ISSUES
Putting property in joint tenancy or deeding it with a reserved life estate will avoid probate while preserving the basis step-up, but there are other considerations. The most important is the loss of control over the property. Depending on the nature of the property and how it is titled, the donor may lose the ability to dispose of the property without the permission of other owners. With bank accounts, the opposite problem arises; other joint tenants have full access to the funds and may remove them at will. There are work-arounds for these issues. For example, the grantor may insist that the grantees execute instruments transferring their interests back so the grantor retains the ability to dispose of the property. There are also problems of delivery and potential gift tax when the plan involves transfers back and forth. Unrecorded or undelivered deeds raise questions about whether the interests are effectively conveyed.
There are many ways attorneys have devised to pass real property to grantees while retaining the grantor’s ability to convey. In simple situations, one Michigan lawyer tries to cover all the contingencies as follows: His client executes a quit claim deed, signed by two witnesses including a notary. Witnesses are not necessary for a deed in Michigan, but are necessary for a will. By having witnesses, the deed is effective as a will even if challenged as a deed. He then attaches to the deed a written instruction from the grantor to the personal representative or trustee, signed and dated the same date as the deed, stating that the deed should be delivered to the register of deeds upon the grantor's death, and that it is intended to convey title to the grantees at that time. In the written instruction the grantor expressly reserves the right to otherwise convey or encumber the property. The grantor also indemnifies the agent for any penalties or other problems that might be caused by delayed recording of a deed.
Some states also permit “transfer-on-death” deeds. The grantor conveys the property to grantees, effective on death. The deed is immediately recorded and the death certificate of the grantor is recorded at the appropriate time, completing the transfer.
IX. SALE OF PRINCIPAL RESIDENCE
A quit-claim deed could cause a tax problem if the original owner wanted to sell the principal residence and exclude the gain under IRC § 121. Up to $250,000 11 of gain may be excluded on the sale of the principal residence,12 but if the seller does not own the whole property the gain exclusion may be prorated based on the interest owned.
The statute does not explicitly state that the seller must have exclusively owned the principal residence for two years. The full exclusion should be available if all of the interests are transferred back to the original owner before the sale, but neither the regulations nor cases interpreting § 121 clarify this issue.
If the seller is the only resident and has used the house as his or her principal residence for two years, the whole gain should be excludable despite a gift back of gratuitous joint tenant interests immediately before the sale. However, some experienced and knowledgeable tax attorneys hold the opposite opinion. They argue that the seller must have been the sole owner for the whole two years preceding the sale. Until there is a definitive regulation or case, the matter will remain open to dispute.
The statute also contains this provision:
At the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately.13
After sorting out all the negatives, subsection (d)(8)(A) seems to apply to the situation where the owner has conveyed a remainder interest in the property, followed by a sale. If the remainder is sold at the same time as the life interest, the seller may elect to cover both interests under the capital gains exclusion.
The IRC § 121 problem and the other complications raised by diluting ownership of one’s property make joint tenancy or a transfer with a reserved life estate for estate planning an issue that should be approached with care. However, in some cases these simple devices are not only the least expensive but the most sensible way to effect the transfer of an estate on death.
There is a widespread myth that putting property in joint tenancy or transferring property subject to a life estate confers a present interest and impairs the basis step-up on death. This is incorrect. The gift of a joint interest or putting an intended beneficiary’s name on property, retaining a life estate, does not take the property out of the donor’s gross estate. Since property that is included in the gross estate for Estate Tax purposes receives a step-up in basis, it is considered acquired by reason of death and capital gains tax is calculated with regard to fair market basis as of the death of the donor, not carry-over basis. There are some disadvantages to using a quit claim deed for estate planning. Adding names to one’s home will dilute ownership for gain exclusion on sale of the primary residence. This is a problem if the home is to be sold during life. Also, joint tenancies can make sale of property difficult or allow joint tenants to block desired transactions. Therefore, despite their utility and ease of use, quit claim deeds and other forms of dispersed ownership should be carefully analyzed. Otherwise the original owner may find himself or herself deprived of the benefit of valuable property.
1 26 USCA § 1014. The personal representative may choose an alternate valuation date up to six months after death or use the date of disposition for property disposed of within six months. 26 USCA § 2032(a). The rule is subject to technicalities irrelevant to the present discussion. [Back to Top]
2 26 USCA § 1014(b)(9). [Back to Top]
3 26 USCA § 2040(b). But see 26 USCA § 1014(b)(6), which confers a full step-up for community property even though the survivor's interest is not included in the decedent's gross estate. [Back to Top]
4 Half of the property retains its original tax basis of $5,000. The other half is stepped up to $50,000. [Back to Top]
5 26 U.S.C.A. § 2033. [Back to Top]
6 26 U.S.C.A. § 2040(a). [Back to Top]
7 26 U.S.C.A. § 2040(a). [Back to Top]
8 26 U.S.C.A. § 2036. [Back to Top]
9 Id. [Back to Top]
10 26 U.S.C.A. § 1022. [Back to Top]
11 For a married couple, the exclusion is $500,000. [Back to Top]
12 26 USCA § 121. A married couple may exclude up to $500,000. [Back to Top]
13 26 USCA § 121(d)(8)(A). [Back to Top]