If you’ve ever purchased real estate, you have been confronted with the question of how to take title. You’re typically given a few options and asked to check one. Maybe you accepted the suggestion of your mortgage broker, realtor or the notary sitting at the table with you. The selection of how to take title is an important one. Choose wisely.
As a California estate planning attorney, I very often encounter clients who took title in a way that is not the most advantageous from an estate planning and income tax planning perspective. Often, I see married couples take title as “husband and wife, as joint tenants.” There’s good and bad with taking title this way. The good is that upon the death of one joint tenant, the other joint tenant becomes the owner of 100% without having to open up a formal probate. The bad is that the surviving spouse will not get a “step up” in tax basis at the death of the first spouse to die.
Your “tax basis” in an asset is generally the price you paid to acquire the asset. Your tax basis will be used later to determine the gain (or loss) realized when that asset is sold or otherwise transferred. If you take title as “husband and wife, as joint tenants” only one-half of the property (the deceased spouse’s half) gets a step up in basis. The surviving spouse’s half retains the original tax basis.
If you instead take title to real estate as “husband and wife, as community property,” the surviving spouse’s half will also get a step up in basis at the death of the first spouse to die. Now, the surviving spouse’s new tax basis for the entire property will be the fair market value of the entire property at the decedent’s spouse’s date of death. When the surviving spouse sells or otherwise disposes of the property later, the taxable gain will be much smaller and will potentially be less than the limits of Internal Revenue Code §121 which excludes from income gains of up to $250,000 upon the sale of a personal residence if certain other conditions are met. There is no such exclusion for the sale of investment real estate, so the step up in basis would be even more valuable in this context. If you think about the increase in value in California real estate over two or three decades, a step up in basis for the entire property at the death of the first spouse to die could be quite valuable.
Fortunately, correcting how you hold title is easily corrected by executing and recording a new deed. Often, during the process of funding a client’s new revocable living trust, we implement a two-step process to first transfer title to community property, then to the new revocable living trust. This should ensure that the surviving spouse gets a step up in basis as to 100% of the real estate at the death of his or her spouse thus potentially substantially reducing future income taxes.
Every situation is different and this article is not intended to be universally applied without analysis. There may be other considerations that would cause an attorney to recommend an alternative course of action. Please consult a competent attorney.