Q. My late husband and I bought our home 45 years ago for $50,000, and we were then advised to take title as Joint Tenants to avoid probate. When he died 3 years ago, I was told by a realtor that it was worth about $1.2 Million. I was recently told by our CPA that, if I were to sell it, I would have a steep capital gains tax to pay. Is that so and is there any way around that.
A. Yes, your CPA is correct.
Basically, capital gain is the difference between your net sales price and your original cost (plus improvements). It is your “profit” from the sale of your home. Assuming no improvements, your capital gain in this situation would be $1,150,000 ($1,200,000 — $50,000), before adjustments. But you are entitled to some adjustments to this total gain:
Date of Death Adjustment: Under current tax law, when an owner dies, his ownership share gets an adjustment to its date of death value. We often call this a “step up” in cost basis. However, when a couple holds title in Joint Tenancy form, only the deceased spouse’s share gets the “step up”. Yours does not. So, in that situation, the adjusted cost basis would be $625,000, calculated as follows:
Husband’s ½ share: $600,000
Your own ½ share: + $ 25,000 (1/2 of $50K purchase price)
Adjusted Cost Basis $625,000
However, if you and your husband held title in Community Property form, then BOTH HALVES would get the “step up” in cost basis, and your adjusted Cost Basis would then be calculated as follows:
Husband’s ½ share: $600,000
Your Own ½ Share: + $600,000
Adjusted Cost Basis $1,200,000
In effect, by holding title in Community Property form you would get a “double step up”, which would wipe out all capital gain up to the date of death of your husband!
$250K Home Use & Ownership Adjustment: In either situation, under the tax code you would also be entitled to claim a $250K capital gain exclusion available to an owner who has lived in the home at least 2 years before sale. In the Joint Tenancy situation, this would help reduce – but not eliminate –the capital gain. In the Community Property situation, this exclusion might not even be needed, except perhaps to the extent there were further appreciation between the date of your husband’s death and your actual date of sale.
B. So, is there any way to convert Joint Tenancy title to Community Property form after the death of your spouse?
Answer: Yes, if your purchase was before 1985. In 1985, the law changed in California to require a writing to re-characterize your Joint Tenancy home to actually be Community Property.
However, assuming that your purchase was before 1985, and assuming that you and your husband purchased your home with earnings and savings from your marriage and understood it to be community property, it would actually be community property in character under California law, even if it were not so titled. In this situation, you might initiate a rather basic court proceeding called a “Spousal Property Petition”, asking a Superior Court judge to issue a Court Order finding that the home is, in fact, Community Property, passing to you without probate. With such an order in hand, you could then claim the “double step up in cost basis” when reporting the gain on the sale of your home, dramatically reducing or even eliminating your capital gain and its corresponding tax. However, this assumes that you purchased your home before 1985, when the operative statute in California (Family Code § 852) changed: before the change, the fact that you used community funds to make the purchase and truly considered this home your community property could be sufficient for the court to grant relief. However, after 1/1/1985, a writing to that effect would normally be required.
One caveat: While the IRS is not necessarily bound by a state trial court order, I have not known the IRS to routinely dispute this procedure and have used it successfully in the past to eliminate capital gain in similar situations. [See Commissioner v. Estate of Bosch, referenced below.], But see the Estate of Wayne-Chi Young case, also discussed below.
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References: California Probate Code § 13650; Commissioner v. Estate of Bosch, 387 U.S. 456 (June 5,1967) [held: where federal estate tax liability turns upon the character of a property interest under state law, federal authorities are not bound by the determination made of such property interest by a state trial court. If there is no decision by the state’s highest court, federal authorities must apply what they find to be the state law after giving “proper regard” to relevant rulings of other courts of the state. Id at pages 457, 462–466. See, further, Estate of Wayne-Chi Young v. Commissioner, 110 T.C. No. 24, Doc 98-14934 (1998) disregarding a state court finding that a couple’s real property held as “Joint Tenancy” would be deemed Community Property, where the couple had failed to transmute their Joint Tenancy into Community Property by the requisite transmutation writing required by state statute on and after January 1, 1985, per Family Code § 852. In this case, there was no contention that the transmutation had occurred prior to 01/01/1985 (the date of the writing requirement in the CA statute), where the Commissioner of Internal Revenue was not brought in as a party in the probate proceeding, and where the proceeding was not litigated in an adversarial proceeding. All that said, where the surviving spouse can truthfully allege in state court that the “transmutation to Community Property” occurred prior to 1/01/1985, even the Young case acknowledges that a writing was not then required: all that would then have been required was “substantial credible and relevant evidence”. Id at page 14.. So, assuming the allegation to be true, be sure to allege that the transmutation occurred on or before 12/31/1984.unless you have a writing to which you can point that clearly and unambiguously indicates an intent by both spouses to change the Joint Tenancy property into Community Property.