Community Property Offers Tax Benefits
After my recent column about joint tenancy, several married readers wrote to ask whether they should own the family home as “joint tenants” or as “community property.”
So I asked several probate and estate-planning specialists what they would advise. Most of them suggested that the home be held as community property, primarily for tax savings, although some never even bothered to change their own house deeds from joint tenancy, because there may be other ways to obtain the same benefits.
Only Married Couples
Torrance lawyer Jeremy H. Evans explains that he believes community property usually offers the best advantages for ownership of the family home. It’s only for married couples, although he says he’s actually had clients who have asked: Can my brother and I hold this property as community property?
The advantage of holding property in joint tenancy is that it is “automatically” transferred upon death without having to go through probate. (There is still some paper work involved; you must file an affidavit of surviving joint tenant and other papers with the county recorder to clear the property title into your name alone.) Another benefit is that the value of the property is not included in the estate when determining the percentage of probate fees for the executor and lawyer.
The biggest advantage to holding the home as community property is potential tax savings. When your home is held as community property, under federal law, you’ll get 100% of something accountants and tax lawyers call the “stepped-up basis.” With joint tenancy, you may lose 50% of this tax advantage.
But, first, you should understand the concept. Under Internal Revenue Service rules, when you buy real or personal property, the original value of the property--usually, the purchase price--is your “basis” in the property. When you sell the property, you will be taxed on the difference between the selling price and your basis. So if you buy a painting for $500 and sell it for $1,500, you pay tax on $1,000 of income.
Upon death, the basis in your property is automatically increased to its fair-market value to the benefit of your heirs. So if you die before you sell the painting, your heirs will inherit it and have a basis in it of $1,500, the amount it was worth upon your death. Then, when they sell it, they only have to pay tax on the amount they receive above $1,500.
‘Only Windfall’
It is the “only windfall you get for having died, and it can be quite considerable,” attorney Evans says.
To further clarify, let’s use another example: You and your spouse buy a home for $100,000. If you sell it 10 years later for $250,000 and don’t buy another home (so you can’t “roll over” the income), you will have to pay tax on the $150,000 gain. (This all assumes you are under age 55, after which there are other tax advantages at the time you sell your home.)
The original purchase price, the $100,000, is your “basis” in the property, and when you sell, everything you make above the basis is taxable. (The basis also includes the value of improvements to the property, but let’s forget about that in our example.)
If you own the home as community property, and if the surviving spouse inherits the house, he or she receives a stepped-up basis in the entire property, according to federal law. So, in our example, if the husband dies when the house is worth $250,000, the wife’s basis will be $250,000. Then, when she sells the house, she only has to pay tax on the amount she receives above $250,000, even though the couple originally paid only $100,000 and already profited to the tune of $150,000. So if she later sells the house for $300,000, she has to pay tax on only $50,000 in income.
The wife will have to go through probate to clear title to the house, but it’s not very complicated if all the estate is left to the surviving spouse.
On the other hand, if the house is owned in joint tenancy, the surviving spouse will own the house “by operation of law” without having to go through probate, but will only get a stepped-up basis in half of the house. In other words, the wife will have the original basis of $50,000 for her share in half of the house (half of the original $100,000 basis) and the additional stepped-up basis of $125,000 (because the house is worth $250,000) for the other half of the house she receives upon her husband’s death, for a total basis of $175,000.
If she sells the house for $300,000, she will have to pay tax on $125,000 in income. There will be a $100,000 gain on her half and a $25,000 gain on her husband’s half.
That’s quite a big difference in taxable income. Fortunately, there are other ways to obtain the same tax advantages. Even if the deed in your house says it is held in joint tenancy, a lawyer can file a petition during probate on behalf of the surviving spouse, asking for a court determination that the home was actually held in community property. You have to show that the home was purchased by community funds and other facts to support its community-property character, Evans explains, and it usually is not very difficult to do.
That’s one reason why some lawyers don’t think it is necessary to rush down to the recorder’s office to change your deed from joint tenancy to community property. If you are planning to make such a change, you’ll be relieved to know that doing so will not be considered a taxable change in ownership under Proposition 13 and will not create a gift tax, according to Beverly Hills tax lawyer Paul Hoffman and other tax specialists.
Of course, if you purchased your home with separate funds, holding title to it in community property may raise other questions if you ever find yourself in divorce court.
Furthermore, if your house has not appreciated much in value, the savings in probate costs from joint tenancy may be more valuable than the tax advantage of community property ownership.
And if you do own real estate in joint tenancy, and your joint tenant dies, make sure that you clear title to it by recording the appropriate documents with the county recorder. Otherwise, your heirs may have a messy tax situation to face when they inherit the property.
Tax and estate planning are very personal matters that should be discussed with your accountant or lawyer. These general principles are helpful, but you should carefully consider your particular situation with an experienced adviser before making any choices.
Attorney Jeffrey S. Klein, The Times’ senior staff counsel, cannot answer mail personally but will respond in this column to questions of general interest about the law. Do not telephone. Write to Jeffrey S. Klein, Legal View, The Times, Times Mirror Square, Los Angeles 90053.
