Take-Away: It may be possible, albeit in highly limited circumstances, for a surviving spouse to claim a 100% basis adjustment when their spouse dies.

Background: I recently spoke with a widow, named June, who was in the process of selling the ‘family cottage.’ June’s decision was premised on the fact that she was too old to use the cottage and the expense to maintain the cottage was too high for her budget and, more importantly, her financial peace mind as a widow. In addition, both of June’s kids live a long way away and they seldom got back to use the Michigan cottage. June was bemoaning the capital gain taxes that she expected to incur on the sale of the family cottage. June and her husband (Harvey) had purchased the ‘rough’ cottage and lake lot back in 1972. At the time, June was a stay-at-home mother. The down payment came from Harvey’s earnings. Harvey also spent many weekends over many summers slowly improving their family cottage as a ‘fixer-upper.’. The cottage was purchased in 1972 for $30,000 ‘down’ with a total purchase price of $90,000.  Harvey’s earnings also paid the $60,000 mortgage over the next 20 years. The title to the cottage was taken by June and Harvey as tenants by the entireties. Over the years June estimates that she and Harvey made periodic improvements to the cottage, e.g., new roof, new septic, bathroom remodels, of about $60,000. But now, nearing the age of 78 and dealing with the loss of Harvey a couple of years ago, June plans to simplify her life by selling their beloved northern Michigan family cottage for $830,000 (an informal offer was made to her by the kids of her neighbors next door.) I suggested to June that perhaps the capital gain tax liability that she faces on the sale of the family cottage may not be nearly so bad.

IRC 2040(b)- 50% Inclusion Rule: This Tax Code section provides that in the case of a qualified joint interest held by a husband and wife, the value of that interest that is included in the gross estate of the deceased spouse with respect to such interest is one-half the value of such qualified joint interest. A qualified joint interest is any property that is held by the decedent and the decedent’s spouse as joint tenants or tenants by the entireties, but only if (i) such joint interest was created by the decedent, the decedent’s spouse, or both; (ii) in the case of real property, an election under IRC 2515 applied with respect to the creation of that joint interest; and (iii) in the case of a joint tenancy, only the decedent and the decedent’s spouse are joint tenants. Consequently, as a generalization, for most jointly held assets, there is a 50% income tax basis adjustment on the death of a spouse, since only 50% of the fair market value of the jointly held asset is included in the deceased spouse’s gross estate for federal estate tax calculation purposes. [IRC 2040(b).]

Example: June and Harvey purchased the cottage for $90,000. They also, over the years, made improvements to the cottage of $60,000 resulting in an income tax basis in the cottage of $150,000. Assume the cottage had a fair market value of  $810,000 at the time of Harvey’s death. One half the value of the cottage at Harvey’s death is $405,000, which is included in Harvey’s gross estate. When added to the original tax basis that June and Harvey have in their cottage ($150,000) June’s income tax basis in the cottage is $550,000. If June sells the cottage for $830,000, she will incur a capital gain of $280,000, and a capital gain tax of about $56,000.

IRC 2040(a)- Contribution ‘Test:’ This Tax Code section provides: “The value of the gross estate shall include the value of all property to the extent of the interest therein held as joint tenants with right of survivorship by the decedent and any other person… in their joint names and payable to either or the survivor, 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 in money or in money’s worth.” Thus, for normal jointly owned property, excluding spouses, the person who contributes the consideration to acquire the jointly held asset includes the full fair market value of the jointly owned asset in the contributor’s gross estate on death, which is known as the ‘contribution test.’

After 1976: IRC 2040(b) was added to the Tax Code in 1976. However, the 1976 Tax Act provides that IRC 2040(b) applies only to a joint interest that is created after December 31, 1976. Prior to that date, the Tax Code used, and continues to use, the contribution test [IRC 2040(a)] which applied to a joint spousal interest that was created before 1977. [Black v Commissioner, 765 F.2d (9th Circuit, 1985.) Therefore, the 50% estate inclusion rule applies to joint interests created by spouses but only those created after 1976.  For qualified joint interests created before 1977 the contribution test still applies as to what is included in the deceased spouse’s gross estate.

Example: Same facts as above with June and Harvey. However, since the source of the entire consideration used for the purchase of the Michigan cottage was Harvey, as he was the only spouse working during the marriage when the cottage was purchase, its mortgage paid, and the improvements made, the entire fair market value of the cottage at Harvey’s death, $810,000, is included in Harvey’s gross estate. That then becomes June’s income tax basis in the cottage, while that joint ownership arrangement also qualifies for the unlimited marital deduction on Harvey’s death. Therefore, when June sells the cottage for $830,000, her income tax basis will be $810,000, and she will therefore pay a capital gain on $20,000 9the growth in value after Harvey’s death), or about $4,000. Unlike portability which requires an affirmative election on a Form 706 filed after Harvey’s death in order for June to be able to use Harvey’s unused applicable exemption amount, there is no need for June to make an affirmative election after Harvey’s death on his estate tax return in order for her to claim that the full (100%) fair market value of their cottage is included in Harvey’s gross estate on his death, resulting in a full basis step-up.

This 100% income tax basis adjustment was confirmed in the Gallenstein decision which controls the tax consequence in Michigan when a jointly held asset was acquired prior to 1977..

Lee Gallenstein v. United States, U.S. District Court, E. Dist. Kentucky (September 18, 1991)

Overview: This case, which originated in the federal court in eastern Kentucky, was decided in 1991 in favor of Mrs. Gallenstein. That decision was appealed by the IRS to the Sixth Circuit Court of Appeals in 1992, which covers Michigan. The Appeals Court also held in favor of Mrs. Gallenstein, giving her a 100% basis step-up upon the death of her husband, while it also ordered the IRS to pay Mrs. Gallenstein’s court costs and legal fees.

Facts: Mr. and Mrs. Gallenstein purchased farmland in 1955 using Mr. Gallenstein’s earnings. The farmland was owned jointly by them. The purchase price for the farmland was $103,000. Mr. Gallenstein died in 1988. Mrs. Gallenstein a few years later sold the farmland for $3,663,650. Mrs. Gallenstein’s original income tax return initially showed a gain of $3,556,596 on the sale of the farmland,  since she only deducted the original purchase price (the purchase price basis) of $103,000. Mrs. Gallenstein subsequently filed an amended income tax return to update the tax basis of the farmland to $1,838,685 to reflect one-half of the fair market value of the farm land when Mr. Gallenstein died [consistent with what IRC 2040(b) provides.] In response, the IRS then issued a refund of $105,395 to Mrs. Gallenstein. Then, on a final amended return, Mrs. Gallenstein requested a refund of another $115,152 which reflected the adjusted the cost basis to 100% reflecting the farmland’s fair market value at the time of Mr. Gallenstein’s death.

Litigation Issue: The IRS refused to issue the second tax refund to Mrs. Gallenstein, which prompted her to file her lawsuit in federal court to seek her tax refund. Mrs. Gallenstein claimed that since her joint interest in the farmland was created before 1977, and that Mr. Gallenstein paid the purchase price for the farmland, IRC 2040(a) required that the full fair market value of the farmland had to be included in Mr. Gallenstein’s gross estate [IRC 2040(a)], with the result of a 100% step-up in tax basis to the farmland. In response the IRS argued that the Economic Recovery Tax Act of 1981 (ERTA) repealed, by implication, the effective date of IRC 2040(b), arguing as a conclusion that the Tax Reform Act of 1976 provided that only one-half of the fair market  value of qualified joint interest was includible in Mr. Gallenstein’s gross estate.

District Court: The Court noted that the language of the tax statutes is the best indication of legislative intent, and when there is no ambiguity in the language of statutes, resorting to the legislative history to interpretate such language would be unnecessary and improper. Accordingly, the Court concluded that the 1976 and the 1981 provision were not in irreconcilable conflict and that the 1981 provision did not cover the whole subject of the 1976’s IRC 2040.  The Court held that there was no implied repeal of the effective date of IRC 2040(b) and the ERTA did not change the non-applicability of this provision to pre-1977 joint interests. In sum, Mrs. Gallenstein was entitled to a tax refund because the spouses’ joint interest in the farmland was formed prior to 1977 and Mr. Gallenstein contributed all of the funds to purchase the farmland, thus leading to a 100% basis step-up on Mr. Gallenstein’s death by applying IRC 2040(a).

Appeals Court: The Court of Appeals did not add much to the technical analysis provided by the District Court interpreting the 1976 and 1981 tax Acts. It clearly states that if the decedent spouse was the sole contributor to a jointly held asset (with a spouse or any other third party) then the entire fair market value of the joint owned assets is included in the decedent’s gross estate.

Caution: This favorable result for a surviving spouse is not available when an election was made under former provisions of the Tax Code, IRC 2040(d); this election, which had to be made during 1977, 1978 or 1979, allowed pre-1977 joint interests to be treated as qualified joint interest property that was governed by IRC 2040(b).

Conclusion: The obvious point is that a jointly owned asset by spouses that was acquired prior to 1977 and which was acquired solely by one spouse’s contributions, will entitle that asset to a 100% basis adjustment on the contributing spouse’s death, just as if the asset was community property. If the non-contributing spouse dies first, then the jointly owned asset will receive a 50% basis adjustment on his/her death. Something like a northern Michigan cottage that has been held in the family for multiple decades, acquired through the earnings of one spouse, may enjoy a full basis step-up after the contributing spouse’s death. However, the date that the jointly held asset was originally acquired is a sometimes overlooked fact, or simply presumed to have occurred sometime after 1976. The Gallenstein rule is an exception to IRC 2040(b) which can greatly help to minimize capital gains if a surviving spouse decides to sell an asset that was acquired through joint ownership from his/her deceased spouse.