Joint Ownership, Joint Trusts and Basis Step-up

Take-Away: There is not much mystery to the income tax basis of jointly held assets between spouses. Yet there is one wrinkle that might be exploited by some couples with long ago acquired jointly owned property.

Background: With the high applicable exemption amount and portability of a deceased spouse’s unused applicable exemption amount (DSUEA) more married couples are inclined to adopt a joint trust as part of their estate plan with the goal of ‘keeping it simple.’  A joint trust helps to avoid the expense and publicity associated with probate, while functioning much like an “I Love You” Will, where everything held in the joint trust is left to the surviving spouse. Less attention is given to the income tax basis of assets that are held in a joint trust on one spouse’s death.

Income Tax Basis: A joint trust is treated pretty much like all other joint ownership between spouses, so that there is a 50% income tax basis adjustment, i.e. step-up (or step-down) on the death of one spouse with regard to the assets held in their joint trust. [IRC 2040(a); IRC 1014(a)(1).] As a result, the estate of the first spouse to die will include one-half of these qualified joint assets and will report such joint holding on Schedule E(1) of the decedent’s Form 706 federal estate tax return, if a return is filed. The inclusion of these joint assets for estate tax purposes will not increase the decedent’s estate’s potential estate tax liability because the qualified joint interests will also qualify for the marital deduction as assets that pass to the surviving spouse by operation of law. [IRC 2056.] The application of IRC 1014 is mandatory, such that it will apply even when no federal estate tax return is filed by the deceased spouse’s estate.

Joint Ownership Presumption: The Tax Code also creates a rebuttable presumption that the first owner of jointly owned property to die contributed 100% to the acquisition of the joint property and that the entire property is include in the decedent-joint owner’s gross estate. [IRC 2040(b).] To rebut this presumption, a tracing rule is available to individuals who can demonstrate that the surviving joint tenant contributed to the acquisition of the jointly owned property. The tracing rule thus allows for an allocation of the property between two joint tenants based on their respective contributions to the jointly owned property.

Gallenstein: For joint tenancies that were created by spouses before 1977 there is a departure from the general 50% estate inclusion rule of IRC 2040(a). In Gallenstein v. United States, 975 F.2d 286 (1992) the Court held that such joint interests are governed by the contribution-tracing rule that was in effect before the 1981 Tax Act, and thus it is still in effect for joint tenancies for some married couples. Inclusion of this old jointly held property in the estate of the spouse first to die, therefore, is determined by which spouse contributed how much of the consideration for the acquisition of the jointly held property. As the entire property passes through the estate of the first spouse to die under Gallenstein, IRC 1014 mandates a corresponding effect on the basis adjustment of the jointly held asset. Consequently, the entire interest in the property will receive an income tax basis adjustment to its fair market value because the entire interest was included in the estate of the first spouse to die. The IRS initially balked at this interpretation, but it later acquiesced, thus making it relevant even today, almost a decades later. Consequently, joint interests created by spouses before 1977 are taxed on the death of the first spouse under the rules of IRC 2040(b), effectively avoiding the 50% inclusion rule of IRC 2040(a).

Basic Example: Fred and Wilma own their cottage as tenants by the entirety. Their income tax basis in the cottage is $100,000. At the time of Fred’s death, the cottage’s fair market value is $400,000. Even if no federal estate tax return is filed by Fred’s estate, Wilma’s income tax basis in the cottage will be increased to $250,000 [one-half the original basis of $100,000 divided by 2, plus one-half at the fair market value of the cottage of $400,000 divided by 2, or $50,000 + $200,000 = $250,000.]

Gallenstein Example: Fred and Wilma acquired their cottage in 1970, purchased by Fred with his own funds, but Wilma’s name was added to the deed at that time as a matter of convenience. Thus, Fred contributed 100% of the purchase price for the cottage. Because of Gallenstein, the entire cottage will be included in Fred’s gross estate for federal estate tax calculation purposes. Wilma will take an income tax basis of $400,000 in the cottage, which is the fair market value of the entire cottage at the time of Fred’s death. The entire $400,000 is reportable on Fred’s estate tax return, but it also generates a $400,000 marital deduction that results in no federal estate tax liability. Note, too, that the Gallenstein rule will apply whether or not Fred’s estate files a federal estate tax return. Hopefully Wilma will be made aware of her new, properly computed,  income tax basis in their formerly jointly-owned cottage. Accordingly,  if Wilma decides to sell the cottage shortly after Fred’s death, she will not pay any capital gains taxes. Or, if Wilma decides to hold onto the cottage but lease it as an income-producing rental, Wilma’s depreciable basis in the cottage will increase, thus improving her income tax deductions for future years.

Basis Planning with Joint Trusts: Sometimes  spouses will attempt to structure their joint trust to achieve a full 100% income tax basis adjustment on the death of one spouse. In this situation, the two spouses create and fund a jointly established revocable trust, with each spouse owning a separate share of that joint trust. Each spouse possesses the right to amend and/or revoke his/her portion of the joint trust without the consent of the other, while both of the spouses are then living. The first spouse to die is granted a testamentary general power of appointment, i.e. the right to appoint all trust principal among a class that includes that spouse, his/her creditors, and the creditors of his/her estate. Upon the death of the first spouse, the entire corpus of the joint revocable trust (both portions) is included in the deceased spouse’s taxable estate under IRC 2041 and thus should thus qualify as property that is acquired from a decedent under IRC 1014.  The Tax Code provides:

“[e]xcept as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passes from a decedent shall….be the fair market value of the property as of the decedent’s death.” [IRC 1014(a)(1).] The Tax Code further states that: “Property Acquired from the Decedent” includes “property passing without full and adequate consideration under a general power of appointment exercised by the decedent by Will.”

IRC 1014(e) Exception: While the above would suggest that the spouses can gain a 100% income  basis adjustment to assets held in a joint trust by virtue each holding a testamentary general power of appointment over all assets held in the joint trust, that is generally frustrated by yet another Tax Code section. The Tax Code prevents an income tax basis step-up if  property was acquired by the decedent within one year of death, and such property is then transferred to the original donor of such property on the decedent’s death. This exception applies to all donors and donees, not just spouses. [IRC 1014(e).]

The IRS’s position in several private letter rulings and also in a formal Technical Advice Memorandum (TAM) is that while joint trusts may be used to pull all assets into the estate of the first spouse to die and be available to fund a credit shelter and/or a marital trust, an income tax basis step-up is not permitted due to IRC 1014(e). In other words, even if the deceased spouse does not exercise the general power of appointment, the fact that immediately prior to the one spouse’s death they could direct the other spouse’s portion of the joint trust’s assets by virtue of the general power of appointment over all trust assets is treated as if the deceased spouse’s power over the other spouse’s portion of the joint trust came to the deceased spouse immediately prior to, i.e. within one year, of the deceased spouse’s death.

Solutions: If the goal is to obtain a full (100%) step-up in the income tax basis on the death of one spouse using a joint trust, consider the following options:

Transfers in Trust: One possible solution to the limitation imposed by IRC 1014(e) is to exercise the power of appointment and cause the trust property subject to the power of appointment to directly pass in trust for the benefit of the surviving spouse. The plain language of IRC 1014(e) implies that this Code section is applicable only to outright transfers back to the surviving spouse, not to transfers to a trust that is established for the benefit of the surviving spouse/original owner. While this might work, there is an equally good chance the IRS will fight that convenient interpretation of IRC 1014(e).

Transfer on Death Account: Some assets that might be otherwise be held in a joint trust  and that will promptly be disposed of by the surviving spouse, e.g. hunting cabins; hobby and collectible assets, might be better held in  the owner-spouse’s own name, or in a separate transfer-on-death (TOD) account, a payable-on-death (POD) arrangement, e.g. a partnership interest, or real estate that uses a transfer-on-death deed coupled with a beneficiary designation. These ‘outside the joint trust’ ownership arrangements would enable the one spouse who wants to own and/or enjoy the subject assets to hold the asset outside of the joint account, but cause the asset to pass directly on their death (avoiding probate) to the spouses’ joint trust. As a result, the TOD/POD asset will be held  in the decedent-spouse’s own name at the time of their death, and thus subject to a full IRC 1014(a)(1) income tax basis adjustment to its date-of-death value. That asset then passes directly to the joint trust via the beneficiary designation. The surviving spouse, as the sole successor trustee and lifetime beneficiary of the joint trust, can then sell the asset from the trust with its adjusted (higher) income tax basis.

Conclusion: The 50% basis adjustment rule for jointly held assets by spouses is fairly simple to understand and apply. However, in some cases, if an old pre-1977 jointly owned asset is part of the deceased spouse’s estate, it may be possible to claim a 100% income tax basis adjustment. And while joint trusts are popular between spouses for several good reasons, there may be situations where I might make more sense to hold an asset out of the joint trust, rely on a TOD or POD beneficiary arrangement to transfer the ‘outside’ asset into the joint trust on one spouse’s death. This decision may turn on what the proposed surviving spouse plans to do with the asset if they survive their spouse.