When a husband and wife hunt for a home, they consider factors such as the neighborhood, the quality of the school district, curb appeal, or the condition of the house. However, they frequently overlook something else that is perhaps just as important: how they take title to their new home. It’s a fact that most married couples choose joint tenancy. However, joint tenancy will create future tax liabilities if one of the spouse dies and the property is sold. A married couple can escape this tax liability by simply taking title as community property (CP) or community property with right of survivorship (CPWROS). The only time the IRS will forgive you for the capital gains on your home is if you vested title as CP or CPWROS. So you should take advantage of it!
In California, most married couples will hold title to their homes in joint tenancy because they don’t seek legal counsel, they are not well informed, or because someone told them that holding title in joint tenancy escapes probate. However, holding title in joint tenancy escapes probate only after the first spouse’s death and creates tax liabilities if the property is sold by the surviving spouse.
How is it that joint tenancy creates future unnecessary tax liability? Look at an example. John and Jane, a married couple, bought a home in California for $100,000 in 1980 and in 2015 it is worth $ 1 million dollars. John dies in 2015. Jane sells the property for $1 million dollars following his death. What is Jane’s cost basis in computing how much income tax she will owe? The couple originally bought their home for $100,000 and Jane is still alive; therefore, her cost basis is $50,000 or half of the original price. When John dies, Jane receives John’s 50% share of the house AND John’s stepped up cost basis as well. Because Jane is receiving John’s 50% after his death, she is receiving John’s stepped up cost basis, which includes half of all the appreciation in the value of the house. When John died, the house was worth $1 million dollars; therefore, John’s 50% cost basis would be stepped up to $500,000. When Jane sells the property for $1 million dollars minus her cost basis of $50,000 and John’s stepped up basis of $500,000, her taxable proceeds would now be $450,000 ($1,000,000 minus $50,000 minus $500,000 = $450,000). The bottom line here is that in joint tenancy, there is ONLY a 50% or half stepped up in cost basis, whereas if John and Jane held title of their home as CP or CPWROS, then the stepped up tax basis would be 100% and Jane will have to pay ZERO in taxes!
Holding title as CP or CPWROS is a good method for paying NO income tax for your surviving spouse in the future. Lets look at the same example. Instead of taking title in joint tenancy to their home, they took title as CP or CPWROS. When John dies the house is worth $1 million dollars. Jane sells the house for $1 million. How much tax does Jane now need to pay? The answer is ZERO tax liability! Why? Because, when Jane sells the house for $1 million dollars, her cost basis is also $1 million dollars. This is because Jane received a 100% or full stepped up cost basis since the home was vested as CP or CPWROS and not held in joint tenancy.
Therefore, a husband and wife should strongly consider holding title to their home as CP or CPWROS because after the death of the first spouse, the surviving spouse can sell the house and not pay any taxes on the appreciated value of the home. However, the best method in vesting title is a living trust.
source: Law Offices of Paul Horn