Tuesday, June 23, 2009

Eliminating Capital Gain on Real Estate Owned By Married Couples: A Simple Yet Critical Strategy

How do you hold title to your home? Odds are, if you are 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.

Here’s the downside: If you hold real estate in Joint Tenancy with your spouse, 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:

Max and Marge bought a house and took title as Joint Tenants. They paid $200,000 for the home (their cost basis for the purposes of calculating capital gain is therefore $200,000). Thirty years later, Max passes away. At the time of Max’s death, the property has increased in value to $1,150,000 (this assumes an annual appreciation of 6% over a 30 year period). Since Marge gets a “step up” in cost basis to 50% of that amount ($575,000), her new cost basis is $775,000 (her initial basis of $200,000 + Max’s stepped up basis of $575,000). Assuming that Marge chooses to downsize and sell the family home immediately, she will have capital gain in the amount of $375,000 ($1,150,000 sales price – her new $775,000 cost basis). At best (assuming Marge had lived in the home for 2 out of the last 5 years), she will have $250,000 of that $375,000 exempt from capital gains tax. But she’s still left subject to capital gains tax on $125,000 when she sells. This will result in a pretty hefty tax bill.

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, Marge’s new cost basis will be the full market value of $1,150,000, and she will be able to sell the property for zero capital gain. Moreover, if she chooses to remain in the residence (or even rent it out for a few years), she will still be able to rack up an additional $250,000 in appreciation and sell it tax free down the line.

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 would 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 property, opting for the “with Right of Survivorship” designation makes perfect sense.

If you are buying a new home or refinancing and would like to take advantage of taking title as Community Property with Right of Survivorship, it is as simple as checking the appropriate box in your closing documents. If you already own a home in Joint Tenancy and would like to change how you hold title, no problem. You can simply sign a new deed transferring your property from yourselves as Joint Tenants, to yourselves as Community Property with Right of Survivorship. Ask your title company or a competent attorney to assist you.

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