Obscure Tax Break Can Mean Thousands to Couples

President Clinton has proposed eliminating a major tax break for married couples in California and other community property states. But you’ve heard little outcry--perhaps because few people know the tax benefit even exists.

And that’s too bad, because California couples with large gains in their taxable accounts or in their homes could leave the surviving spouse thousands of dollars poorer for their ignorance.

The tax break is called a double step-up in basis, and it is available only to married couples who title their assets as community property rather than hold them as joint tenants.

Like most areas of tax law and estate planning, this area is complicated, ever-changing and subject to nuances that are impossible to entirely capture in a newspaper column. Smart investors will consult tax advisors and estate planning attorneys before making wholesale changes in how they title their accounts.

But you probably want to figure out if this situation affects you.

First you have to understand what a tax basis is. Generally, it’s what you originally paid for an asset--stock, mutual fund, house, racehorse, whatever. When you sell the asset, that basis is subtracted from your sale price to determine your taxable profit. (There are other factors that affect basis, but you get the general idea.)

If you die still owning the asset, the asset receives a new tax basis--generally its fair market value on the day you die. This is usually a real bonus to your heirs. When they sell the asset, they would owe taxes based on the difference between the sales price and the new (generally higher) tax basis.

If you hold the property in joint tenancy with a spouse, then your spouse gets the new step-up in basis on your half of the property when you die. But your spouse’s basis remains the same.

In other words, say you and your spouse spend $5,000 to buy 100 shares of a stock for $50 each. When you die, the stock is worth $20,000. Your half of the stock, or $10,000 worth, would get a new $10,000 basis. Your spouse’s half would keep the original basis of $2,500 (half of the $5,000 you two spent to buy the stock). (See accompanying chart.)

Had you owned the shares as community property, however, your surviving spouse would get an extra tax gift. Both halves of your holdings--yours and your spouse’s--would get a step-up in tax basis. So instead of a $12,500 basis, your spouse’s new basis would be $20,000--and your spouse wouldn’t owe a dime in taxes if the stock were sold for that amount.

Owning a home as community property rather than in joint tenancy can also have benefits, particularly if the house appreciates enormously in value over the years.

Here’s another example of how the basis step-up works. A home purchased for $100,000 is worth $500,000 when the husband dies. The wife, as a joint tenant, gets a new $300,000 tax basis, her half at her $50,000 basis plus the husband’s half stepped up to $250,000.

If she sells the home a few years later for $600,000, she would have $300,000 in potentially taxable gain.

Because a special rule excludes $250,000 of home sale profit from tax, she would owe capital gains taxes on the remaining $50,000.

If, on the other hand, the home had been titled as community property, her new basis would have been $500,000 after the husband’s death, and the entire gain from the later sale would have been untaxed thanks to the exclusion rules.

Of course, the step-up works both ways. If your accounts or real estate lose value, your widowed spouse is stuck with a double step-down in basis. Still, over time, real estate and stocks tend to grow in value rather than shrink, making the concept a winner for most California couples.

“The community property step-up seems to me to be a free ride,” said Burton Mitchell, an estate planning attorney with Jeffer, Mangels, Butler & Marmaro in Los Angeles. “It could help a lot or it could help a little.”

To comply with Internal Revenue Service rules, your accounts must be titled as community property to get the double step-up in basis. Once upon a time, some tax advisors suggested you could title property as joint tenants and still get the tax advantage simply by writing a letter, to be shown to the IRS in case of an audit, stating that the property was being held this way “for convenience only” and that it should be treated as community property for tax purposes.

More recent case law and statutory changes suggest that the tactic won’t work, said James Ellis, chairman of the California Bar Assn.’s estate planning, trust and probate law section.

“Under California law, you’re pretty well bound by the form of title,” Ellis said.

That, however, raises other issues. Property held in joint tenancy avoids probate, the often expensive and lengthy court process otherwise used to settle an estate. Community property does not avoid probate--although it can qualify for a simpler and faster summary probate.

Many couples create a living trust to avoid probate, but the title of property must be placed in the name of the trust. The good news is that, generally speaking, assets that are first titled as community property retain that character and tax treatment even when retitled as trust assets, as long as the trust doesn’t say otherwise, Ellis said.

Most well-written trust agreements will include language that confirms that assets within are to be held as community property. That will help couples who first held the property as joint tenants to get the community property step-up in basis, Ellis said.

Obviously, the more assets you have, the larger the potential tax consequences. But there are many, many other factors to consider, from potential estate tax scenarios to the stability of your marriage. It could be a bad choice to retitle your property if you’re about to get divorced, for example.

Also, you should know that certain assets can’t be titled as community property. Retirement accounts, for example, have to be held in one name and generally don’t have a tax basis to begin with. Life insurance and accounts with a designated beneficiary usually are not titled in joint tenancy or as community property.

The double step-up in basis is coming under political attack. Clinton’s proposed budget this year, just like his proposal last year, includes a provision that would eliminate the double benefit. How much support the double basis step-up has is unclear; the benefit is generally available only to married couples in nine community property states: California, Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

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If you have more questions, that’s not surprising. Again, this is an enormously tricky area, and it pays to have expert tax and estate planning advice--in other words, talk to a professional. The California bar certifies specialists in estate planning; you can search for such specialists at https://www.calbar.org. With stock markets booming and home prices soaring, the special treatment available to community property is something worth talking about.

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Liz Pulliam Weston regrets that she cannot respond personally to queries, but questions about money can be sent to her at liz.pulliam@latimes.com.