The Law of Unintended Consequences: Potential Traps of Do-It-Yourself Estate Planning

Consider this scenario.  Dad is 75 years old and decides to add his son’s name to a piece of Michigan real estate he purchased five years earlier for $200,000.  Today that real estate is valued at $300,000.  The new deed reflects father and son as joint tenants with the intention of the son assuming ownership upon the father’s death.  The legal term for this is Joint Tenancy with Rights of Survivorship (JTWROS).

The plan seems simple enough and Dad is pleased because no probate will be needed at his death for this real estate to pass to his son.  But what the father doesn’t realize is that by retitling the real estate he effectively made a gift to his son for federal gift tax purposes.  Although the tax consequences of adding a joint tenant differ depending on the type of asset, the type of joint ownership, and the applicable state law, they could be substantial.  Here are some of the likely tax ramifications:

  1. Tax Return.  The father must file a gift tax return by April 15 of the year following the year of the gift to report the value of the gift.
  2. Value of the Gift.  All joint owners of JTWROS property in Michigan must consent to a change in the joint ownership (the joint ownership is not unilaterally severable).  Therefore, the value of the gift to the son must be determined actuarially using IRS tables.  This computation gets especially tricky if there are more than two joint tenants.
  3. Annual Gift Tax Exclusion.   The annual gift tax exclusion ($14,000 per donee in 2015) only applies to gifts of a present interest (unrestricted right to immediate usage and enjoyment).  Is adding the son’s name as JTWROS a gift of a present interest?  In some ways, the joint tenant may have a present interest (for example, if the joint tenant shares in income from the property, if any).  But in other ways, the last surviving joint owner does not have a true fee interest until the other joint owner dies.  This has been identified as an issue since at least the 1960s, and the current thinking still leaves this question up for debate.
  4. Estate Tax Inclusion.  Interestingly, even though Dad made a gift of a portion of the real estate to his son, the entire value of the real estate is includible in the father’s gross estate for estate tax purposes because he furnished the entire amount of the consideration for the real estate.  This “consideration furnished rule” applies to non-spousal JTWROS assets.  Such inclusion may trigger an estate tax at the father’s death, depending on the value of his other assets and the amount of the applicable exclusion amount available.
  5. Income Tax Basis.  Basis is the amount of capital investment an owner has in an asset and is used to determine gain or loss on the sale of the asset for income tax purposes. The carryover basis rule for gifts says that the son takes some portion of the basis Dad had in the real estate (the purchase price of the real property plus certain additions).  But 100 percent of the value of the real property ends up in the father’s estate because of what the law refers to as the consideration furnished rule for non-spousal JTWROS property.  So does the son end up with 100 percent step up in basis on his father’s death?  The tax laws generally provide a step up in basis to the extent the value of such property is included in a decedent’s gross estate.  Therefore, if the real estate is includible in the father’s gross estate under the consideration furnished rule, such inclusion might step up the son’s basis in the real estate at his father’s death.  However, if father and son sell the real estate prior to the father’s death, both of them must recognize the capital gain between them ($300,000 – $200,000 = $100,000 capital gain).
  6. Gift Tax Payment.  If the father has sufficient applicable exclusion amount, no federal gift tax will be paid with the gift tax return; however, the taxable portion of the gift will be deducted from his applicable exclusion amount.

This is only a brief summary of the significant issues surrounding jointly owned assets, and there are many exceptions.  And as you can see, it is a very complex issue.  When considering estate-planning scenarios, it will be well worth the time and effort to discuss your ideas with a qualified estate advisor to help avoid tax traps similar to the JTWROS problem.

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