COST BASIS RULES: JOINT TENANCY 

When someone inherits an asset, it can be difficult to understand what their potential tax liability will be, especially if they already owned an interest in that asset. In this article, we are going to discuss what California residents need to know about cost basis adjustments after the death of a spouse or non-spouse joint tenant, and how community property rules compare to the joint tenancy rules for married couples.

I. THE BASICS

First, we will begin covering the basic definitions and examples of cost basis, step-ups in basis, joint tenancies, and tenants in common.

Cost Basis

The cost basis of an asset is the amount paid to purchase that asset. In other words, if you invest in assets like stock or real estate, your cost basis will be the price, or the “cost” of that asset on the day you bought it. Knowing your cost basis is important, as it will help you determine your profit or loss, and ultimately your tax liability when you choose to sell your asset. Your capital gain or loss upon the sale of your asset, is the difference between its cost basis and the sales price.

Example. You purchased an asset for $10,000, and your cost basis is still $10,000 when you later decide to sell that asset at fair market value (“FMV”) for $15,000. After the completion of the sale, you will have taxable gain on $5,000, the difference between your cost basis and the sales price.

Your cost basis in an asset can be adjusted over the time you own the asset. For example, in the case of real estate, your original basis can be adjusted down by depreciation taken each year and adjusted up by capital improvements. However, in order to keep the concepts simple, the remaining examples in this article will treat cost basis simply as the original purchase price.

Step-Up in Basis

Many people are familiar with the term “step-up in basis” or a “stepped-up basis”. A step-up in basis occurs when an inherited asset’s FMV on the date of the decedent’s death exceeds its original purchase price. In this case, the tax code allows the cost basis of the asset to be raised to the value it was on date of the decedent’s death, which can significantly reduce the capital gains tax to be paid by the asset’s beneficiary if they choose to sell it later.

Example. A single father purchased his home in 2000 for $100,000, and he later died in 2023 leaving the home to his sole child. The home was worth $500,000 on the day the father died. Although the father’s cost basis was $100,000, the child’s cost basis will be raised, or stepped-up to $500,000, the FMV of the asset on the father’s date of death. This is significant, because now if the child chooses to sell the home, capital gain taxes will only be applied against the difference between $500,000 and the sales price, and not the difference between $100,000 and the sales price. Of course, in the situation where a decedent’s asset’s date of death value is lower than the decedent’s cost basis, the cost basis of the asset would be stepped-down instead of stepped-up.

Joint Tenancy with Right of Survivorship vs. Tenancy in Common

1. • Joint Tenancy

     A joint tenancy with right of survivorship, or simply a “joint tenancy”, involves two or more co-owners who own property together in equal shares. Upon the death of a joint tenant, the decedent’s share automatically passes to the surviving joint tenant(s) by operation of law. This process is otherwise known as the “right of survivorship”. However, do not be misled by the word “share” in the preceding sentence, as it is more important to understand that each joint tenant owns an entire asset together with the other joint tenants, and not a fractional interest as would be the case in a tenancy in common.

   • Tenancy in Common

     A tenancy in common is a form of co-ownership in which two or more parties own specified fractional interests in a common property, and thus each tenant in common’s interest is not required to be equal. Since a tenant in common interest is considered a wholly distinct interest, when a tenant in common dies, their fractional interest in the property passes to their estate and does not automatically transfer to the other tenants in common pursuant to a right of survivorship.

Now that we have covered these concepts, and clarified that joint tenants pass interest to one another by operation of law, we can specifically look at the different way basis is adjusted upon the death of a joint tenant.

II. JOINT TENANCY BASIS ADJUSTMENT – NON-SPOUSE VS. SPOUSE

Upon the death of a joint tenant, you must first determine whether any of the joint tenants are spouses, as that will make a difference in how the adjusted cost basis is calculated.

Basis Adjustment After Death of Non-Spouse Joint Tenant

As discussed above, a decedent’s interest in property held in a joint tenancy will pass to the surviving owner by operation of law, and therefore considered property acquired from the decedent. When the survivor and the decedent are not spouses, the surviving joint tenant’s adjusted cost basis in the property consists of the following:

• • The FMV of the decedent’s interest in the property, plus
  • The survivor’s original cost basis in their original interest in the property.

Example: A brother and sister purchase real estate (the “Property”) as joint tenants in 2000 for $1,000,000.  The brother paid $750,000 (75%) of the purchase price and the sister paid the remaining $250,000 (25%). In 2023, the brother died when the Property had a FMV of $2,000,000. Therefore, $1,500,000 is the FMV for the brother’s interest at his death (75% of $2,000,000).

Now the sister, as the surviving joint tenant, will now own the entire Property by operation of law.  Her adjusted cost basis in the Property will consist of her original basis in the Property, plus the FMV of Brother’s interest at his death (the “step-up”).  (See calculation below)

$1,500,000 (The step-up in basis for the brother’s interest)

 + 250,000  (The sister’s original basis)

$1,750,000 (The sister’s adjusted basis)

Therefore, if the sister sold the Property soon after the brother’s death for $2,000,000 (the FMV), the sister’s capital gain liability will apply to the difference between the sales price for the Property and the sister’s adjusted basis in the Property. (See calculation below)

$2,000,000 (Sale price)

– 1,750,000 (The sister’s adjusted basis)

$250,000 (Subject to capital gain tax)

 

2. Basis Adjustment After Death of Spouse Joint Tenant.

Unlike the calculation for non-spouse joint tenants, the calculation for married joint tenants is made irrespective of each spouses’ personal contributions at the time of the joint tenancy’s creation. If spouses hold property as joint tenants, the surviving spouse’s total basis in the property is the following:

• One-half of the FMV of property on the date of the decedent’s death, plus
• One-half of the original cost basis, minus
• The surviving spouse’s share of any depreciation taken on the property prior to the decedent’s death.

Now let us apply this calculation to the same facts above, but to keep things simple, we will say that neither spouse took depreciation on the Property before the husband’s death. (See calculation below)

$1,000,000 (The half step-up in cost basis for the married couple’s interest)

 + 500,000  (Half the married couple’s original basis)

$1,500,000 (The wife’s adjusted basis)

Therefore, if the wife sold the Property soon after the husband’s death for $2,000,000 (it’s FMV), the wife’s capital gain liability will apply to the difference between the sales price for the Property and the sister’s adjusted basis in the Property. (See calculation below).

$2,000,000 (Sale price)

– 1,500,000 (The wife’s adjusted basis)

$500,000 (Subject to capital gain tax)

As you can see, considering each joint tenant’s original contributions can make a big difference in the adjusted basis. The sister’s tax liability in the first example is half of the wife’s tax liability in the second example. However, as described below, a married couple will greatly benefit by avoiding taking title as joint tenants in community property states.

III. FACTORING IN COMMUNITY PROPERTY RULES

In community property states like California, married couples should take ownership of assets as their “community property” instead of as joint tenants, because the community property rules pertaining to basis after the first death are much more advantageous. If one spouse dies, the cost basis of the community property gets fully stepped up to the FMV of the property at the first death.

Example: If a couples’ community property home was purchased years ago for $1,000,000 and it is now worth $2,000,000 upon the first spouse’s death, the surviving spouse will receive a full step up from the original cost basis from $1,000,000 to $2,000,000, and if the surviving spouse sells the property right away, he or she will little to no capital gains taxes.

In conclusion, it is important to understand that owning property as joint tenants (as opposed to as tenants in common) will result in a basis adjustment for a co-owner upon the death of joint tenant, and the calculation of said basis adjustment will depend on whether the joint tenants were spouses. Further, if you live in a community property state like California, married couples should take title of their collective property as their community property instead of as joint tenants, as the community property rules pertaining to basis adjustment are more advantageous than the rules for married joint tenants.