Understanding Joint Tenancy and Tax

An overview of the intersection of estate tax treatment and income tax treatment of joint tenancy interests

There is a lot of misunderstanding about joint tenancy with rights of survivorship. At its core, this is essentially a form of ownership which strips away a right that is central to U.S. property law - the right to transfer property at death - to streamline the vesting of title of property at the death of a co-owner.

The way this works is that, if a joint tenant dies, their interest automatically passes to the other surviving joint tenants. The last joint tenant left standing ends up as the sole owner, at which point the form of title converts from joint tenancy to fee simple ownership.

From an income tax perspective, we approach this two ways - the split of income and deductions from the property (such as rents, depreciation, etc.) between joint owners, and the split of sales proceeds between joint owners. Interestingly, what many people don't realize is that, in order to maintain the economics of the right of survivorship, each joint tenant must have equal ownership. So, for example, if you have two joint tenants, they will always have 50/50 ownership. Likewise, four joint tenants would always each have 25% ownership.

Where things get confusing, however, is the tax treatment of a joint tenancy interest at death. While it is rare for the estate tax to apply due to a very high exclusion (currently $12,060,000, and increasing to $12,920,000 in 2023), there is one economic measure - the gross estate - which applies to both the estate tax and the income tax. This is important to know, because assets included in the gross estate (other than income earned but not received before death) have their income tax basis changed. This is a step-up in basis for interests in property which have appreciated in value during a decedent's life, but it could also be a step-down in basis for property interests which have depreciated in value.

How does this relate to joint tenancy? Well, there are some interesting rules around joint tenancy and its effects on the gross estate.

As a starting point, the gross estate includes all assets a decedent owns at death. But, it also includes property for which the decedent had no ability to control ownership at death. So, even though the right of survivorship takes away a decedent's right to transfer the interest at death, their joint tenancy interest is still included in their gross estate. And, there is no discount in the value for a fractional ownership, or for the inability to control the transfer of the property at death. Contrast this with tenancy in common (fractional ownership without the right of survivorship), for which there may be a discount for fractional ownership.

Internal Revenue Code Section 2040 sets forth these interesting rules, and breaks down joint tenancy between spouses and non-spouses. The lowest hanging fruit is spousal ownership, which includes the deceased spouse's undiscounted 50% ownership in the gross estate. This 50% is generally based on the fair market value of the property at the deceased spouse's death (unless the alternate valuation date is elected, which requires the rare outcome of estate tax actually being owed). The outcome? When one spousal joint tenant dies, this 50% ownership gets a step-up (or step-down) in income tax basis to 50% of the date-of-death fair market value of the entire property. These rules also extend to tenancy by the entirety, which can only exist between spouses in states that recognize this form of property ownership.

Where things get confusing, however, is the tax treatment of non-spousal joint tenant interests. This requires us to again consider the date-of-death fair market value, but also potentially the value of the property at each time a joint tenant was added to the title if the joint tenant contributed only part, but not all, of the value of their interest at the time.

The easiest situation to consider is where a joint tenant interest is gifted in full. Take, for example, a parent who adds their child to the title as a joint tenant. This would be a gift of 50% of the value of the property at the time that the child is added to the title. (Contrast this with adding a joint tenant to a bank or investment account, which is not treated as a gift unless or until the new joint tenant actually withdraws funds from the account). If the parent then dies, it is easy to assume that the parent's 50% joint tenant interest is included in the gross estate based on the spousal rule above. But, this is not the end of our analysis. IRC Section 2040 also requires the parent to include the gifted joint tenant interest in their gross estate.

The outcome? Both the parent's 50% joint tenant interest that they owned at death, and the 50% they gifted away, get a step-up or step-down in basis under IRC Section 1014(b)(9) based on the fair market value of the entire property at the parent's death. But, this is not the end of the equation. IRC Section 1014(b)(9) also looks to whether the child took any depreciation deductions between being added to the title, and their parent's death. (As noted above, the child's 50% ownership entitles them to 50% of the depreciation deductions each year).

So, if the child took this depreciation on their 50% ownership, they do not get to re-depreciate their own 50% interest even though the basis is adjusted at their parent's death. But, they do get to depreciate the 50% ownership acquired from their parent. If the child immediately turned around and sold the property for its gross estate value, they would only have to pay tax on the appreciation in value of their 50% ownership (including recaptured depreciation on their 50%).

If that wasn't confusing enough, let's take another situation where consideration is involved. To start, there are two basic transfer tax principles any estate planner should know. One, a sale is not a gift except if the consideration paid is less than the fair market value of the property at the time of the sale. In this case, the gifted amount would equal the discount given in the sales price. Two, property gifted during life which is deemed to be included in the gross estate due to retained ownership and control is usually reduced by consideration actually paid, based on the value of the consideration received at the time of sale (see IRC Section 2043).

But, these rules get turned on their head when non-spousal joint tenancy is involved. Keep in mind, as I noted above, that joint tenancy requires equal ownership among joint tenants. If two joint tenants make unequal contributions to the purchase of property, they cannot skew their ownership percentages to match their contributions. This has an interesting effect under IRC Section 2040 and 1014(b)(9).

Let's take a situation where a parent wants to help a child purchase a home. The child puts in 20% of the purchase price, and the parent puts in 80%. Instead of structuring it as a loan, they decide to title it as joint tenancy. That way, if the child predeceases the parent, the parent recoups their investment through right of survivorship, and vice versa for the child. However, the use of joint tenancy means they cannot title the property 80/20 - it has to be titled 50/50. Essentially, this means that the parent gifted a 30% joint tenancy interest to the child.

The result under IRC 2040 is that the 30% gifted joint tenancy interest is included in the parent's gross estate, but not the 20% actually contributed by the child. In this regard, we have to go back to the time that the child was added to the title to determine the fair market value, as the proportion of that value represented by the child's contribution (the consideration furnished) will be respected as the child's ownership. This means, at the parent's death (if they predecease the child), 80% will be included in the parent's gross estate and will be subject to the adjustment to basis under IRC Section 1014(b)(9). (Presumably, if the child was using the property as a personal residence, there would be no 30% share of depreciation to subtract from this adjusted basis).

Again, this means the child can immediately turn around and sell the property for its gross estate value, and only pay tax on the appreciation in value attributable to their 20% ownership. On the other hand, if the property had gone down in value since purchase, the child could only claim 20% of the loss (since the other 80% of the loss would be wiped out through a step-down in basis for the parent's deemed 80% ownership for gross estate purposes).

Interestingly, as well, this means that the date-of-gift consideration rule under IRC 2043 is not applied. The parent gets credit for the appreciation attributable to the consideration furnished by the child for their 20% interest. Contrast this with a situation where IRC Sections 2036 or 2038 apply, in which case the consideration credited against gross estate inclusion (and adjusted basis) would only be based on the date-of-purchase, and not date-of-death, proportionate value of this consideration.

Now, while I have applied these rules to real estate so far, this could also extend to an investment account. For example, when a parent who adds a child to an investment account under the facts and analysis above, 100% of the securities get a step-up or step-down in basis, based on the fair market value of each security's position at the parent's date of death. This value is based on the average between the high and low selling price on the date of death, or if there was no trading activity on that day, a reverse weighted average of the high and low selling prices on the trading days that straddle the parent's date of death.

Long story short, it is important to know how joint tenancy is treated not just from a titling, estate planning, and asset protection perspective, but also from a tax perspective. The latter perspective is perhaps the greatest gap in knowledge I have observed from an educator's seat.