In today’s article, we will explore the negative tax consequences of transferring real estate to your children through joint tenancy.1DuVal. Basis Rules of Joint Tenancy (Jul 26th, 2019) https://www.cpapracticeadvisor.com/tax-compliance/article/21089491/basis-rules-of-joint-tenancy. This is a common method of avoiding probate, but is it worth it? And do you create more problems than you solve by transferring property in this manner?
This information is provided for informational purposes, and you should consult a licensed CPA before making any decisions that affect your tax burden and a licensed Estate Planner (attorney) for considerations affecting inheritance. And, if you are a child who has received property from a parent, and you need help selling your inherited property, call me for a free evaluation of your options.
If you want more information, or if you want to verify my work, I include sources in footnotes throughout the article. Footnotes appear as tiny numbers at the end of each sentence like this.2This is an example of a footnote.
Before we get too deep in the taxes, let’s look at what Joint Tenancy is and why people might use it to avoid probate.
What is Joint Tenancy?
When a person takes ownership of a home with more than one other person, this is called cotenancy.3Law.com Cotenancy https://dictionary.law.com/Default.aspx?typed=cotenancy&type=1 (Last accessed July 28, 2020). Cotenants must choose how to hold title. Choices include: Tennants in Common, Joint Tenants, Tenants by the Entirety, Community Property, or a combination of these types.4Investopedia.com 5 Common Methods of Holding Real Property Title https://www.investopedia.com/articles/mortgages-real-estate/08/title-ownership-property.asp (Last accessed July 28, 2020). Put simply, joint tenancy is a method of describing the the rules of how the ownership of your property should be handled under the law.
Why do people use it to transfer property to children?
When a property owner selects “Joint Tenancy” as the ownership type, the owner declares to all the world that he or she wishes to transfer ownership of any person’s interest to the other owners upon any one owner’s death.5Law.com, Joint Tenancy https://dictionary.law.com/Default.aspx?selected=1049 (last accessed July 28, 2020) This avoids the probate process and is commonly referred to as the “Poor [Person’s] Will.”6Owada, The Trouble of Joint Tenancy https://www.sterlingandtucker.com/report/the-trouble-with-joint-tenancy/ (last accessed July 28, 2020) This makes joint tenancy a common method for parents to transfer property to children-heirs in the later years of their lives.7DuVal, Basis Rules of Joint Tenancy (July 26, 2019) https://www.cpapracticeadvisor.com/tax-compliance/article/21089491/basis-rules-of-joint-tenancy (last accessed July 28, 2020).
For example, let’s say that Mary (age 80) transfers title to her children as follows: “Mary grants title on 123 Main Street to Mary, John, and Sue as joint tenants.”
Once executed (signed), this document takes Mary’s 100% interest in 123 Main Street and divides it into three equal parts owned by Mary, John and Sue. If Mary, John or Sue die, then the surviving parties each have one-half interest.
Most parents presume that they will die first. If Mary dies first, then John and Sue each have 1/2 ownership of 123 Main Street. This ownership transfer requires the filing of an affidavit with the county recorder and requires no probate proceedings or court intervention. We will revisit this example later in the article, so remember Mary, John and Sue.
The question addressed in this article is this: is the advantage of skipping probate worth the negative tax consequences that transferring property through joint tenancy will bring?
What are the negative tax consequences of joint tenancy to you?
Negative tax consequences to you all circle around the concept of gift taxes. When you add your child-heirs to the title of your home, the I.R.S. classifies this as a gift.8Sterling & Tucker, LLP. The Trouble of Joint Tenancy (Last visited July 25, 2020.) https://www.sterlingandtucker.com/report/the-trouble-with-joint-tenancy/ The value of the gift is the portion of the present-day market value of your home that the child receives. The gift must be reported on the taxes of the person making the transfer (called the grantor).
Let’s revisit Mary, John and Sue. When Mary executes the deed transferring title to herself and her children as joint tenants, she gives John and Sue a taxable gift. Let’s assume that Mary’s house is worth $300,000. Mary just gave John and Sue a gift of $100,000 each that must be reported on her taxes!9Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016) https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/ (Any gift over $14,000 to children must be reported on the taxes.)
The good news is that you may not owe any taxes on the gift. Your CPA will help you determine if the gift amount is less than the tax-free gift limit that you are permitted to give children. The bad news is that if you fail to report the gift, you may expose yourself to penalties for failing to report taxable events on your taxes.
Next, let’s see how this event affected the children.
What are the negative tax consequences to your children?
The biggest problem for your children, with respect to taxes, is that the joint tenancy gift also transfers the “cost basis” to the children. 10Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/
This means: if you paid $100,000 for the house, when you add your child to title, your child receives 1/2 a house with a cost-basis of $50,000. 11Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/ This creates a complex transaction which we will now break into two parts. We will treat each half of the house ownership as a separate item from this point forward.
Let us assume the following. You die. Your child files an “Affidavit of Death,” which allows him or her to sell the home. Your child then sells the home for $240,000. Each half of the house then is worth $120,000 (market value). Let’s see what this means with respect to your child’s tax bill.
Step 1: Calculating Tax on the Inherited Portion of the House
The portion that he inherits transfers at market value. Because he inherits your half of the property at market value ($120,000), when he sells the property and receives $120,000 for that half, there are no capital gains.12Double check with your CPA. If you live in a state with a death tax, then there will be a nominal tax on the $120,000 inheritance, which can be as low as 4.5%. 13Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/ In this case, 4.5% of the $120,000 is just $5,400.
Step 2: Calculating Tax on the Gifted Portion of the House
Next, let’s look at the half of the home that you gifted to your child. Remember that when you add your children to title as joint tenants that they take a gift equal to their fair share of the property value. 14Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/
Your children also receive a fair share of the cost basis. 15Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/
In this example, your son received a cost basis of $50,000. When he sold his half for $120,000, he realized capital gains of $70,000. The IRS taxes the $70,000 of capital gains at a rate of about 18%.16Rogers. The Risks of Adding Your Child to Your Home’s Deed (August 11, 2016). https://rodgers-associates.com/newsletters/risks-adding-child-homes-deed/ The tax on the gifted portion of the house will be approximately $12,600.
Step 3: Putting it all together
As you can see above, your son pays $18,000 in taxes on this sale ($5,400 + $12,600), but he could have paid just 4.5% of the entire value of the house if he had inherited the house through the probate process. If inherited through a will, he would only owe $10,800 on the sold house—This is a savings of $7,200.
When you avoid probate by using joint tenancy, you cost your children more money on their tax bill after they inherit.
Above, we saw how using a “poor man’s will” (adding children as joint tenants) costs the children more when it comes time to pay the taxes. This poor man’s will puts more money in Uncle Sam’s pocket and results in less money staying in the family, keeping the poor man or woman poor.
Although probate may cost less than joint tenancy, it may not be the best method of transferring your assets. You should build a team to determine how best to transfer your assets to your children by consulting an estate attorney and a CPA to make sure that you and your heirs keep as much of your hard-earned money as you can.
- When you add your children to title, you must report the transfer on your taxes.
- When your children inherit title through joint tenancy, they will usually pay more taxes than if they inherit through a probate process.
- Consult a CPA and an estate attorney to help plan for the best method of transferring your assets to heirs.