Creating Joint Ownership: Avoiding the Tax Traps and Other Pitfalls

Many property owners add their children and other family members to the title of their property without thinking through the consequences. Many seem to favor joint tenancy—a convenient way to ensure that assets will ultimately pass to family members without the need for probate and other costs. Joint tenancy—commonly referred to as joint ownership with survivorship rights—is usually considered a good idea for husbands and wives. However, with nonspouses, joint tenancy could have costly consequences when used as a quick-fix planning tool without looking at all its implications.

Establishing joint ownership of an asset with one’s child or other (nonspouse) individual is not itself problematic. Most planning professionals have heard the admonishments from cautious attorneys about the unnecessary legal risks. But they may fail to consider the gift tax implications.

WHEN DOES THE GIFT TAX APPLY?
Treas. Reg. § 25.2511-1(h)(4) spells it out clearly: With bank accounts and most brokerage accounts that call for the registration of securities in “street name,” Dad will not have made a reportable gift if he simply adds Junior’s name as a joint owner. Reportable gift transfers occur only if Junior starts to draw funds from those accounts for his personal use (Revenue Ruling 69-148). But with other assets, including a business or even a personal residence, if Dad makes Junior a joint owner, a gift will be deemed to have occurred immediately, and a gift return will probably have to be filed for the year the joint tenancy was created (Treas. Reg. § 25.2511-1(h)(5)).

How should Dad value a gift of a joint tenancy interest in property? If the state in which he lives allows a joint owner of property to sever his interest, then Junior, as a new co-owner, effectively has been granted the right to sell his newly acquired one-half interest. If so, Dad triggers a reportable gift transfer the moment he names Junior a joint owner. The gift is valued at one-half of the property’s value. All Dad needs to do is get a reliable appraisal or valuation of the property. Sounds simple.

Illustration. Jack lives in a state that permits a joint owner to sever his or her interest in property unilaterally. Without having a proper estate plan in place, Jack decides to add his daughter, Liz, as joint owner of a rental property he owns that is valued at $600,000. His action unwittingly triggers a $300,000 gift transaction (one-half of the property’s value). (If Jack is married and owns the property jointly with his wife, each of the parties named on the title would be deemed to own a one-third interest, and the reportable gift to Liz would be $200,000.)

STATES WITHOUT SEVERABILITY
If Jack lived in a state in which a joint owner does not have the right to sever her interest, the rules would be a bit more complex. In those states, Jack would subtract the value of his retained life interest from the full value of the property to determine the value for gift reporting purposes. This value, of course, would be based on Jack’s life expectancy.

Whether or not Jack was married and regardless of his state of residence, it is clear that a substantial gift would have taken place the moment he made Liz a joint owner on the deed. With a gift transfer well in excess of the annual exclusion ($13,000 in 2009, or $26,000 if the gift is split with the donor’s spouse), a federal gift tax return must be filed even if no gift tax is owed at the time (Treas. Reg. § 25.6019-1(f)). Also, there must be full disclosure of the valuation method with the timely filed return to start the three-year statute of limitations ticking, to safeguard the position taken (Treas. Reg. § 301.6501(c)-1)).

Finally, Jack and his tax adviser will need to track this transfer along with planned gifts in the future. If Jack’s accumulated gifts exceed $1 million, a gift tax will be due. The “unified” credit allows for only a $1 million exemption for gifts under current law, even though the estate tax may exempt transfers up to $3.5 million in future years, depending on congressional action.

SECOND-GUESSING JACK’S STRATEGY
You’d probably agree that Jack had better estate planning alternatives available to him. Whichever option is taken, a comprehensive estate planning strategy should have been developed. Clearly, Jack’s advisers should have been able to suggest several alternatives for minimizing unnecessary taxes—including a projection of the capital gains tax that would prevail without the advantage of a basis step-up for the property in question. Based on his decision to create joint ownership with his daughter, Jack will (at the very least) have to deal with a gift tax filing requirement up front—as well as the possibility that he will need to pay gift taxes at some future time.

Next month in Part 2 of 2—valuation of joint tenancy property

—By Thomas J. Stemmy, CPA, CVA, EA, MMS, a partner with Stemmy, Tidler & Morris PA in Greenbelt, Md. His e-mail address is tstemmycpa@yahoo.com.