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2008

Obtaining a Full Step-Up in Basis for Jointly HeldProperty Between SpousesWilliam P. LaPiana

Marc S. Bekerman

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Recommended Citation22 Prob. & Prop. 62 (2008)

Obtaining a Full Step-up in Basis for JointlyHeld Property Between Spouses

By William P. LaPiana and Marc S. Bekerman

Holding property together asjoint tenants with right ofsurvivorship has numerous

advantages to spouses. Among theadvantages are asset protection, dis-ability planning, and possible avoid-ance of a probate or administrationproceeding on the death of the first

William P. LaPiana is the Rita andJoseph Solomon Professor of Wills,Trusts, and Estates at New York LawSchool and a contributing editor to"Keeping Current-Probate." Marc S.Bekerman practices law in New YorkCity and on Long Island, is AssociateDirector and Adjunct Professor ofLaw in the Graduate Tax Program ofNew York Law School, and is a mem-ber of the Section Council.

spouse. Because most assets can beheld in this manner, many marriedcouples own a substantial portion oftheir property in this form. This arti-cle will review a possible additionaladvantage that may be available to asurviving spouse of jointly ownedproperty in jurisdictions that havefavorable law and when properplanning is done both before andafter the death of the first spouse.

Tax Consequences of JointlyHeld Interests

The estate tax treatment of jointlyheld interests is governed by section2040 of the Internal Revenue Code("Code"). The general estate taxtreatment for property interests heldjointly by spouses, usually referred

to as qualified joint interests, is thateach spouse is treated as havingowned a one-half interest in theassets at the time of the first spouse'sdeath (that is, contributions betweenspouses are not traced for estate taxpurposes). Code § 2040(a). As aresult, the estate of the first spouse todie will include one-half of thesequalified joint interests and willreport such holdings on ScheduleE(1) of the federal estate tax return(assuming that a return is required tobe filed). The inclusion of theseassets for estate tax purposes will notincrease the estate's potential estatetax liability because the qualifiedjoint interests will qualify for themarital deduction as passing to thesurviving spouse by operation oflaw. Code § 2056. (Assume that bothspouses are U.S. citizens for purposeof this article.)

The income tax treatment of thequalified joint interests in the handsof the surviving spouse is also fairlysimple in most cases. At the death ofthe first spouse to die, the survivingspouse will not recognize income onreceipt of these assets. Code § 102. Inaddition, the basis of the qualifiedjoint interests will be adjusted to thefair market value of the property atthe time of death to the extent thatsuch interests are included in theestate of the deceased spouse forestate tax purposes. (Assume for pur-poses of this article that no electionsare made regarding potential alter-nate valuations of assets.) Code§ 1014. (The basis adjustments underCode § 1014, often referred to as astep-up in basis, may be a disadvan-tage if the decedent's basis in theproperty exceeds the fair marketvalue of the property at the time ofdeath because then a step-down inbasis would result.) This basis adjust-ment is mandated by the Code and isapplicable even when no estate taxreturn is required to be filed.

Only the one-half portion of thequalified joint interest included inthe gross estate under Code § 2040will receive a basis adjustment underCode § 1014. There will be no adjust-ment to the basis of the other one-half of the qualified joint interest.

62 PROBAIT & PROPEIIIT JANUARY/FEBRUARY 2008

Example-H and W own their resi-dence as tenants by the entirety.Their basis in the residence is$100,000. At the time of H's death,the fair market value of the resi-dence was $400,000. Even if noestate tax return is required to befiled, W's basis in the residence willbe $250,000 (one-half at the originalbasis of $100,000 divided by 2 andone-half at the fair market value of$400,000 divided by 2).

For joint tenancies created byspouses before 1977, there is an inter-esting twist on the general rule setforth in Code § 2040(a). In Gallensteinv. United States, 975 F.2d 286 (6th Cir.1992), the Sixth Circuit held that suchjoint interests are governed by thecontribution tracing rule in effectbefore the passage of the EconomicRecovery Tax Act (ERTA) in 1981 andstill in effect for joint tenanciesinvolving other than married cou-ples. Inclusion of the jointly heldproperty in the estate of the spousefirst to die, therefore, is determinedby which spouse contributed howmuch of the consideration for theacquisition of the jointly held proper-ty. Although the IRS did not acceptthe result in Gallenstein, in 2001 itconceded the point by acquiescing inthe result in Hahn v. Commissioner,110 T.C. 140 (1998), which followedGallenstein. Therefore, joint interestscreated by spouses before 1977 aretaxed on the death of the first spouseunder the rules of Code § 2040(b).

Code § 2040(b) creates a rebuttablepresumption that the first owner todie contributed 100% to the acquisi-tion of the joint property and that theentire property is includable in thatowner's gross estate. To rebut thepresumption, a tracing rule is avail-able to taxpayers who can demon-strate that the surviving joint tenantcontributed to the acquisition of theproperty, which allows for an alloca-tion of the property between the twojoint tenants based on their respec-tive contributions.

In many cases this rule is to thegovernment's advantage in that itmaximizes the value of the estate of

the first owner to die, while placingthe burden of challenging the defaultrule on the surviving joint tenant,who may be unable to provide suffi-cient proof to rebut the presumption.Further, assuming that the survivingjoint tenant lives more than twoyears, the property will be at leastpartially taxable in that survivor'sestate. See Code § 2013 (Credit forTax on Prior Transfers). If the proper-ty passes to a surviving spouse, how-ever, the marital deduction will com-pletely offset the increased value,resulting in no additional estate taxliability.

As the entire property passesthrough the estate of the first spouseto die under Gallenstein, Code § 1014mandates a corresponding effect onthe basis adjustment. Specifically, theentire interest in the property willreceive a basis adjustment to fairmarket value because the entireinterest was included in the estate ofthe first spouse to die. Code § 1014.

Example-Assume that the resi-dence in the prior example waspurchased in 1970. Because theGallenstein rule applies, the entireresidence will be included in H'sestate for estate tax purposes andW would take a basis of $400,000(the fair market value of the entireproperty at the time of H's death).The entire $400,000 reportable onthe estate tax return, however, willalso generate a marital deductionof $400,000, resulting in no estatetax liability on account of thisasset.

One important note is that theGallenstein rule applies whether ornot an estate tax return is required tobe filed. This is especially importantgiven the increasing applicableexemption amount. The survivingspouse, therefore, should be madeaware of the new, properly comput-ed, basis in the formerly jointly heldproperty. In addition, if an estate taxreturn is required to be filed for anestate when the taxpayer has deter-mined that Gallenstein applies, it isappropriate usually to include the

asset on Schedule E(2) of the estatetax returns because the joint interestis not a qualified joint interest underCode § 2040.

As one can imagine, a full step-upin basis with no additional estate taxliability is a highly desirable resultbecause it will reduce the potentialcapital gains on the sale of the prop-erty by the surviving spouse.Further, if the property in question isdepreciable (such as rental realestate), the increased basis will alsoincrease the income tax deductionsavailable to the surviving spouse onan annual basis. (Because of theextremely favorable tax treatment,estate planners should take carewhen considering the severance of ajoint tenancy that would qualify for afull step-up in basis underGallenstein.) Although this result can-not be obtained under Gallenstein ifthe joint tenancy-was created after1976, one question is whether theresult can be replicated with properplanning. The authors propose that,with proper planning under fairlyordinary circumstances, it is possibleto replicate the Gallenstein result inthe majority of jurisdictions.

Use of Disclaimers for JointlyHeld Property Interests

At the end of 1997, the Treasurypromulgated new regulations underCode § 2518 governing disclaimers ofjointly held property by survivingjoint holders. These new regulationssettled the questions surroundingsuch disclaimers in a way favorableto taxpayers. In short, beginning in1998 surviving joint tenants with theright of survivorship and tenants bythe entirety in property other thanbank, brokerage, and other invest-ment accounts can disclaim that por-tion of the jointly held property towhich they succeed. In the case ofjoint tenancies between spouses andtenancies by the entirety involvingother than bank, brokerage, andinvestment accounts, the survivingspouse can disclaim one-half of theproperty regardless of (1) the propor-tion of the consideration for theacquisition of the property furnished

IPIROBATE & PROPEIMT 0 JANUARY/FEBRUARY 2008 63

by the surviving spouse, (2) the por-tion of the property included in thedecedent's gross estate under Code§ 2040, and (3) whether or not theinterest could be unilaterally severedunder local law. Treas. Reg.§ 25.2518-2(c)(4)(i).

Example-W has significantlymore resources than H. Wacquires real property solely withher funds and takes title with H asjoint tenants with right of sur-vivorship or tenants by the entire-

ty. At W's death, H can make aqualified disclaimer of one-half ofthe real property. (The rules gov-erning disclaimers are containedin Code § 2518 and applicablestate law. For purposes of this arti-cle, it is assumed that any dis-claimer is properly executedunder both federal and state lawand that disclaimers of jointly heldproperty are possible under statelaw.)

In this example, if H does not exe-cute a disclaimer, H will receive theproperty with a one-half step-up inbasis under Code § 2040(a). The dis-claimer will not change that out-come, however, because the result ofthe disclaimer is that one-half of theproperty passes through W's probate

estate. That one-half of the propertywill receive a new basis, but in theright circumstances (and perhapswith a further disclaimer by H) theproperty will pass to someone otherthan H, not qualify for the maritaldeduction, and use up part of theapplicable exclusion amount thatmight otherwise be wasted. Indeed,most would assume that qualifieddisclaimers of jointly held propertyby a surviving spouse are usuallymade to mitigate overqualification ofthe marital deduction.

Obtaining the result of Gallensteinfor some joint property arrangementscreated after 1977 is possible becauseof the special rule for disclaimers ofjoint bank, brokerage, and otherinvestment accounts. Treas. Reg.§ 25.2518-2(c)(4)(iii). Under this rule,if the transferor can unilaterallyregain the transferor's own contribu-tions to the jointly held property, asurviving joint holder may disclaimthat portion of the property attributa-ble to the decedent's contribution.The disclaimed property is includedin the decedent's gross estate underCode § 2033 and receives a stepped-up basis.

Example-W has significantlymore resources than H. W opens abrokerage account and deposits inthe account her own funds, whichthen are used to purchase varioussecurities. While H and W areboth alive, W can regain sole own-ership of the account without H'sconsent. At W's death, H maymake a qualified disclaimer of theentire account.

In this example, if H does not exe-cute a disclaimer, H will receive theproperty with a one-half step-up inbasis under Code § 2040(a). But if His the residuary beneficiary underW's will and there are sufficientother assets to pay all expenses andpre-residuary legacies, H's dis-claimer will allow the entire propertyinterest to pass to the estate and thento H as the residuary beneficiary.(Although H receives the disclaimedproperty as a result of the disclaimer,the disclaimer is qualified fortax purposes under Code§ 2518(b)(4)(A).) The result from aproperty law perspective is identicalwhether or not the disclaimer is exe-cuted. Further, there is no additionalestate tax because of the maritaldeduction available to the bequest toH. As the entire property interestpasses through the estate, the entireinterest will receive a step-up inbasis. Thus, the result in Gallensteinhas been replicated regardless ofwhen the joint interest was estab-lished. Note that if H dies first,rather than W, W simply wouldforego a disclaimer and allow theproperty to be treated as a qualifiedjoint interest under Code § 2040(a).

Conclusion

If state law allows for disclaimers ofa jointly held property interest by asurviving spouse in accordance withhis or her contributions to the prop-erty, a significant planning opportu-nity for jointly held financial assetsmay be available regardless of thesize of the estate or when the jointinterest was created. U

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