The opportunity to avoid capital gains tax

On the death of the first spouse Federal tax law and California community property law work together so the surviving spouse receives a full step-up in basis on real property to avoid capital gains tax.  Basis is the purchase price of real property less depreciation, plus improvements to the real property. Capital gain tax is computed on the difference between the selling price and the basis of the property.

California law states real property acquired with community property while husband and wife are living in California is treated as community property. Under IRC Section 1014(b)(6), all of the community property acquired by the surviving spouse  receives a step-up in basis on the entire property based on its fair market value at the date of the first spouse’s death. 

The conundrum, avoid probate or pay capital gains tax

When one joint tenant dies, the remaining joint tenant owns the decedent's interest without probate, by right of survivorship. The law is not that the decedent's interest transfers to the survivor but, rather, the decedent's interest disappears.

Joint tenancy avoids probate. But if the surviving spouse records an Affidavit of Death of Joint Tenant, he or she has unknowingly elected to treat the property as separate property joint tenancy under Federal Law. The IRS will challenge an increase in the basis of the entire property and limit the increase to one-half of the fair market value of the property.

California Law has attempted to square the circle of community property versus joint tenancy with a title designation of “community property with right of survivorship.” The law states: “Community property of a husband and wife, when expressly declared in the transfer document to be community property with right of survivorship, and which may be accepted in writing on the face of the document by a statement signed or initialed by the grantees, shall, upon the death of one of the spouses, pass to the survivor, without administration, pursuant to the terms of the instrument, subject to the same procedures, as property held in joint tenancy.”

Husband and wife transfer into a trust

Trust transfers of real property now become tricky and complicated. A transfer out of joint tenancy into a trust may not be treated as community property by the IRS for a full step-up in basis.

If community property treatment is desired, the more conservative approach is to terminate the joint tenancy expressly when the property is transferred to the trust. The easiest way to do this is to place the language terminating the joint tenancy directly on the deed transferring the property to the trust. Suggested language is: “The grantors hereby terminate their former joint tenancy in this real property and transmute their interests in this real property to community property.”

This potential transmutation to community property has legal issues in the event of divorce or dissolution of marriage. Any separate property interest in property designated in the deed as community property will most likely lose its separate property interest and the other spouse will obtain a one-half ownership in the event of a divorce.

Author’s profile, Mark W. Bidwell is licensed to practice law in California. Office is located at 18831 Von Karman Avenue, Suite 270, Irvine, California 92612. Phone number is 949-474-0961. Mr. Bidwell markets through websites, www.BidwellLaw.com and www.DeedandRecord.com. 

Deed and Record is an online service to prepare affidavits and quit claim deeds for real property transfers into or out of trusts, remove former spouses and gifting. The online service records deeds it has prepared with the appropriate government agency.