Do You Know If Your Property Is Titled The Correct Way?
When a married couple purchases a home or other real property, they will have to make a decision about how to hold title. Prior to July 1, 2001 married couples generally took title as husband and wife as JOINT TENANTS or husband and wife as COMMUNITY PROPERTY. Since July 1, 2001, there is another option, husband and wife as COMMUNITY PROPERTY WITH RIGHT OF SURVIVORSHIP. Each has distinct features, advantages, and disadvantages, some of which are briefly summarized here. I will explain some of the differences between the various forms of title and present factors to consider when determining which form of title is best for you.
JOINT TENANCY
Joint Tenancy has the right of survivorship. At the death of one joint tenant, ownership automatically transfers to the survivor, instantly, as of the time of death. Probate is avoided at the death of the first spouse, however probate may be required at the death of the second spouse. The problem with Joint Tenancy is treatment of gain upon the death of either spouse.
If H and W buy a house for $100,000 as joint tenants and H dies when it is worth $300,000, W’s new tax basis is $200,000. The surviving spouse receives a step-up in basis only for the one-half ‘inherited’ through Joint Tenancy. H’s share is valued at date of death value ($150,000), while W’s share is valued at her historical cost ($50,000). If W sells the house shortly after H dies, she would have a gain of $100,000.
Note: Under the 1997 Tax Act, a single person can exclude $250,000 of gain and a married couple filing joint return can exclude $500,000 on a principle residence if certain tests are met. JOINT TENANCY IS USUALLY THE WORST CHOICE FROM A TAX PERSPECTIVE FOR A MARRIED COUPLE.
COMMUNITY PROPERTY
Community Property does not have an automatic right of survivorship, although interests can be easily transferred to the surviving spouse if no probate claims are filed and there are no contrary provisions in the Will of the deceased spouse. Although title transfers retroactively to the time of death, 40 days must pass before filing the paperwork with the Probate Court to transfer the deceased spouse’s interest to the surviving spouse.
While Joint Tenancy gets a step-up in basis only on 50% of the gain at the death of one spouse, Federal Tax Law allows a step-up in basis on both halves of Community Property.
So, if H and W buy the same house for $100,000 as Community Property, and one spouse dies when it is worth $300,000, the survivor’s tax cost basis is $300,000. Both shares are valued at the date of death value. The surviving spouse could then sell the house for $300,000 and have no taxable gain.
The potential drawback is that Community Property has distinct consequences in the event of a potential future divorce or lawsuit. In general, a creditor first seizes the guilty spouse’s separate property, then the couple’s Community Property; however, the creditor cannot attach the innocent spouse’s separate property.
BENEFITS OF KEEPING PROPERTY SEPARATE
If property is separate (and Community Property can easily be made separate, by a written agreement of both spouses) there are two possible advantages.
Creditor Claims
Separate Property has an advantage since it is not subject to claims of all of the spouse’s separate creditors. It is subject to claims for “community debts” (debts incurred for the family’s general benefit, generally including business debts incurred during marriage), but not for pre-marriage debt or debt in connection with Separate Property (such as when a tenant at his or her separate rental property sues).
Divorce
In a divorce, each party is generally entitled to receive the full value of their Separate Property prior to the division of any Community Property. If property is already owned in Joint Tenancy, conversion to Community Property has no ramifications if a future divorce occurs since each already owns half. However, if Separate Property is converted to Community Property and a future divorce occurs, each spouse would be entitled to half of the value of the converted property. Of course, there is no right of survivorship with Separate Property; so on the death of the owner, without proper estate planning the property must be probated in order to change title.
COMMUNITY PROPERTY WITH RIGHT OF SURVIVORSHIP
As of July 1, 2001 there is a new form of title by which a married couple could take title to real property and have both (1) right of survivorship (which avoids probate) and (2) automatic step-up in tax basis for both spouse’s interest in the real property at the time of the first spouse’s death. Spouses should consider executing and recording new deeds to themselves under the new form of title after July 1, 2001.
LIVING TRUST
In most cases, the best solution to ownership of real estate is a Living Trust. By utilizing a trust, property can be transferred according to the terms of the trust without the probate process and the desired character (Joint/Community/Separate) is maintained within the trust. In addition, a properly drafted trust can avoid probate upon the death of the either spouse and substantially reduce or completely eliminate potential estate taxes. A Community Property Agreement can be used together with a trust to determine which assts will be characterized as community or separate within the trust.