Title Matters: Community Property and Joint Tenancy in California
A married couple in California can take title to their home in different ways. The most common ownership forms are community property and joint tenancy. This article will examine the legal and tax consequences, which may result from each type of ownership upon the death of an owner. I will also briefly review the asset protection benefits of both forms of ownership.
Overview - Ownership Differences
Joint tenancy is a form of ownership where two or more people hold equal rights in the property. A distinguishing feature of joint tenancy is the right of survivorship. Right of survivorship means that upon the death of one of the joint tenants, his or her share is automatically transferred to the surviving joint tenants. Because title transfers by operation of law upon the death of a joint tenant, holding title in joint tenancy avoids probate, a sometimes lengthy and expensive process administered by a court.
The other common way by which married couples hold property is community property. California is one of the nine states that allow for community property. Under community property rules, property acquired by either spouse during a marriage is presumed to be equally owned by both spouses. On the other hand, property acquired before marriage and gifts or inheritance given to either spouse during marriage are considered separate property (unless legally transmuted by either spouse).
Unlike joint tenancy, there is no right of survivorship when title is held as community property. Each spouse may pass their one-half share to their heirs as they please. If the decedent’s community property interest is transferred pursuant to a last will and testament, it will be subject to probate.
Tax Consequences/Basis Step-Up
Capital gains tax is owed on profits made from the sale of an investment. The tax is calculated on the difference between the purchase price when you acquired the asset (basis) and the sales price, multiplied by the prevailing tax rate (note that California taxes capital gains at the same rate as other income). The basis may be increased or decreased during the time of ownership by many factors including property improvements, depreciation, and sales expenses. A “step-up” in basis allows for an adjustment in the basis of assets transferred at death. The basis is “stepped-up” from the adjusted basis to the fair market value of the property at the date of death (or the alternate valuation date, if appropriate). The “step-up” adjustment usually results in a higher basis thus lowering the capital gains tax owed by the beneficiary upon an eventual sale. The basis step-up rules apply differently when property is held in joint tenancy versus community property resulting in potentially different tax consequences.
Basis Step-Up with Joint Tenancy
H and W purchased a house for $500,000 (original basis) in 2000 and took title as joint tenants. H died in 2021 when the house was valued at $1.5 million. Upon H’s death, his undivided one-half interest automatically transfers by rights of survivorship to W, who becomes the sole owner of the house. Only H’s one-half interest is subject to step-up from the original basis. Accordingly, W’s basis in the home after H’s death is adjusted from $500,000 to $1 million (W’s original basis in her one-half interest of $250,000 plus the stepped-up basis of H’s former interest, which is $750,000, one-half of the fair market value at his death). If shortly after H’s death, W sells the home for $1.5 million, there will be a taxable profit of $500,000 subject to capital gains tax.
Basis Step-up with Community Property
Property titled in community property receives a double step-up in basis when the first spouse dies. Using the same facts as the prior example, when H dies, both his share and W's share receive a step up in basis. Accordingly, W’s basis in the home following H’s death increases to the fair market value of $1.5 million. If shortly after H’s death, W sells the home for $1.5 million, there will be no taxable profit and no capital gains tax due.
As the above examples illustrate, titling your home as community property may result in income tax savings because of the double step-up in basis. However, tax savings is not the only consideration that affects the decision of how to hold title of a particular property. Another important consideration is asset protection.
Asset protection commonly refers to strategies used to protect one's wealth against creditors, seizure, or being lost in a lawsuit. Asset protection is among the factors that estate planning lawyers consider when creating a strategic plan.
Just as spouses are presumed to equally own assets acquired during marriage as community property, debts are presumed to be equally owned as well. Accordingly, both spouses generally are liable for debts incurred during the marriage. Therefore, creditors of either spouse can go after community assets to satisfy their obligations. So, when a married couple acquires a home and takes title as community property, creditors of one spouse may go after the non-creditor spouse's share for the satisfaction of the debt. This power of the creditors puts the whole house at some level of economic risk.
Generally, joint tenancy provides better asset protection than community property. When property is titled in joint tenancy, the creditors of one joint tenant can only make claims against that joint tenant's interest in the property. So, when a husband and a wife own their house as joint tenants, creditors of the husband can only reach the husband's one-half interest in the house, not the wife's share. While joint tenancy offers protection to the wife, if the husband is unable to satisfy the creditor’s demands, they may still be able to pursue the sale of the house to get paid from Husband's share. Although creditors will not be able to collect from the wife's share of the house, they may still be able to force the sale.
There is generally never one proper planning strategy that benefits all my estate planning clients. Each is unique with different goals and objectives. This applies to the best way for a married couple in California to take title to property. Although holding title in community property has advantages when it comes to saving capital gains taxes, it may not provide the asset protection benefits of ownership in joint tenancy. A proper evaluation of the facts and circumstances and a well-drafted plan is required to achieve the client’s goals and objectives.