It is a tax rule that will eventually go extinct.
It came to my attention recently that it can – however
– still apply.
Let’s set it up.
(1) You
have a married couple.
(2) The
couple purchased real estate (say a residence) prior to 1977.
(3) One
spouse passes away.
(4) The
surviving spouse is now selling the residence.
Yeah, that 1977 date is going to eliminate most
people.
We are talking Section 2040(b).
(b) Certain joint interests of husband
and wife.
(1) Interests
of spouse excluded from gross estate.
Notwithstanding subsection (a), in the case of any qualified joint
interest, the value included in the gross estate with respect to such interest
by reason of this section is one-half of the value of such qualified joint
interest.
(2) Qualified
joint interest defined.
For purposes of paragraph
(1), the term "qualified joint interest" means any interest in
property held by the decedent and the decedent's spouse as-
(A) tenants
by the entirety, or
(B) joint
tenants with right of survivorship, but only if the decedent and the spouse of
the decedent are the only joint tenants.
In 1955 Mr. and Mrs. G purchased land in Kentucky. Mr.
G provided all the funds for the purchase. They owned the property as joint
tenants with right of survivorship.
In 1987 Mr. G died.
In 1988 Mrs. G sold 73 acres for $3.6 million. She
calculated her basis in the land to be $103,000, meaning that she paid tax on
gain of $3.5 million.
Someone pointed out to her that the $103,000 basis
seemed low. There should have been a step-up in the land basis when her husband
died. Since he owned one-half, one-half of the land should have received a
step-up.
COMMENT: You may have heard that one’s “basis” is reset at death. Basis normally means purchase cost, but not always. This is one of those “not always.” The reset (with some exceptions, primarily retirement accounts) is whatever the asset was worth at the date of death or – if one elects – six months later. Mind you, one does not have to file an estate tax return to trigger the reset; rather, it happens automatically. That is a good thing, as the lifetime estate tax exemption is approaching $13 million these days. Very few of us are punching in that weight class.
Someone looked into Mrs. G’s situation and agreed. In
May 1989 Mrs. G filed an amended tax return showing basis in the land as $1.8
million. Since the basis went up, the taxable gain went down. She was entitled
to a refund.
Three months later she filed a second amended return
showing basis in the land as $3.6 million. She wanted another refund.
This time she caught the attention of the IRS. They
could understand the first amended but not the second. Where were these numbers
parachuting from?
I am going to spare us both a technical walkthrough
through the history of Code section 2040.
There was a time when joint owners had to track their
separate contributions to the purchase of property, meaning that each owner would
have his/her own basis. I suppose there are some tax metaphysics at play here,
but the rule did not work well in real life. Sales transactions often occur
decades after the purchase, and people do not magically know that they need to
start precise accounting as soon as they buy property together. Realistically,
these numbers sometimes cannot be recreated decades after the fact. In 1976
Congress changed the rule, saying: forget tracking for joint interests created
after 1976. From now on the Code will assume that each tenant contributed
one-half.
That is how we get to today’s rule that one-half of a
couple’s property is included in the estate of the first-to-die. By being
included in an estate, the property is entitled to a step-up in basis. The
surviving spouse gets a step-up in the inherited half of the property. The
surviving spouse also keeps his/her “old” basis in his/her original one-half. The
surviving spouse’s total basis is therefore the sum of the “old” basis plus the
step-up basis.
Mr. G died before 1977.
Meaning that Mrs. G was not subject to the new rule.
She was subject to the old rule. Since Mr. G had put
up all the money, all the property (yes, 100%) was subject to a step-up in
basis when Mr. G died.
That was the reason for the second amended return.
The Court agreed with Mrs. G.
It was a quirk in tax law.
The IRS initially disagreed with the decision, but it
finally capitulated in 2001 after losing in court numerous times.
Mind you, the quirk still exists. However, the
population it might affect is dwindling, as this law change was 47 years ago.
We only live for so long.
However, if you come across someone who owned property
with a spouse before 1977, you might have something.
BTW this tax treatment has come to be known by the
widow who litigated against the IRS: the tax-nerds sometimes call it “the Gallenstein
rule.”
