How Do You Hold Title to Your Home?
Odds are, if you're married and purchased real estate with your spouse, you elected to hold the property as Joint Tenants. This has been the common practice recommended by many real estate agents, lenders, and attorneys for quite some time. The advantage to holding property in Joint Tenancy is that, when the first spouse passes away, the deceased spouse’s one-half interest in the property automatically passes to the surviving spouse with little to no transfer cost. Provided that such a transfer of ownership was the couples’ objective upon the first spouse’s death, holding property as Joint Tenants seems like a no-brainer.
The Downside to Joint Tenancy if You're Married
If you hold real estate in Joint Tenancy with your spouse, and the surviving spouse sells a property after a death, you are missing out on significant tax benefits that are available under another method of holding title (which has all of the benefits of Joint Tenancy discussed above) that we’ll discuss in just a moment. First however, we need to understand the basics of calculating capital gain for tax purposes under the traditional Joint Tenancy method. Here’s how it works … when the first spouse passes away, the surviving spouse receives a “step up” in cost basis equal to 50% of the market value of the property at the time of the first spouse’s death (cost basis is, essentially, what you paid to purchase the property). The remaining 50% of the property retains the surviving spouse’s original basis. This concept is best illustrated through an example:
Michael and Kate bought a house together and took title as Joint Tenants. They paid $600,000 for the home (their combined cost basis for the purposes of calculating capital gain is therefore $600,000, with $300,000 of that basis belonging to each of them). Twenty years after they purchased the house, Michael passes away. At the time of Michael’s death, the property has increased in value to $1,590,000 (this assumes an annual appreciation of 5% over a 20 year period). Since Kate gets a “step up” in cost basis to 50% of that amount ($795,000), her new cost basis is $1,095,000 (her initial basis of $300,000 + Michael’s stepped up basis of $795,000). If Kate chooses to downsize and sell the family home after a few years (suppose for instance that she sold 3 years later, at the same 5% annual appreciation, for a price of $1,840,000) she will have capital gain in the amount of $745,000 ($1,840,000 sales price – her $1,095,000 cost basis). At best (assuming the property sold was her primary residence), Kate will have $250,000 of that $745,000 gain exempt from tax. But that still leaves her subject to tax on the remaining $495,000 of gain. This will likely result in over $140,000 in tax liability.
Want to Save $140,000? Here's How...
Fortunately, there is a better option. Since July 1, 2001, married couples have been able to take title to real estate as Community Property with Right of Survivorship. The “Community Property” designation will entitle the surviving spouse to a “double step up” in cost basis equal to 100% of the market value of the property at the time of the first spouse’s death. Therefore, in the example above, Kate's new cost basis at Michael's death would be be the full market value of the property ($1,590,000). If as in the above example she sold the home 3 years later for a price of $1,840,000, Kate will pay no tax on that sale.
It is important to note the significance adding the of the “with Right of Survivorship” language to the Community Property designation. That is what enables the surviving spouse to automatically inherit the deceased spouse’s one-half interest in the property with little to no transfer cost (the same benefit of Joint Tenancy that is often so appealing to married couples). If the property were only taken as Community Property without the “with Right of Survivorship” language, a court process may be required to transfer the deceased spouse’s one-half interest over to the surviving spouse. Therefore, if the couples’ objective is for the survivor to receive full ownership and control over the property (which is often the case), opting for the “with Right of Survivorship” designation often makes sense.
How to Receive Community Property Benefits with Real Estate Held Inside of a Living Trust
When creating a California living trust, it is often advisable to confirm the community property status of real estate that is held in joint tenancy by a deed between the spouses that is signed and recorded as part of the trust funding process.