Alternatives to Comprehensive Estate Planning to Avoid Probate

There are manners in which you can hold title of your property which will avoid probate. All these methods are effective in distributing your property at death, but they do not obviate the need for a comprehensive estate plan as there are numerous disadvantages of each type of ownership.

Assets with Beneficiary Designations

Assets in which you are allowed to designate a beneficiary to receive the property at the time of your death (life insurance, retirement accounts) will pass outside of the probate process.

Pay on Death Accounts

Some savings accounts called Pay On Death accounts (P.O.D.) allow the account holder to designate a beneficiary to receive the account proceeds at the time of your death. For beneficiary designated assets, and P.O.D accounts, if the beneficiary you have designated has predeceased you, the asset will be payable to your estate. Most likely it will be necessary to initiate probate to pass the asset to your heirs.

Joint Tenancy

Holding property with others or "joint tenancy" tenants with right of survivorship avoids probate. California law provides that property held as joint tenants will pass to the remaining joint tenant by "operation of law" and outside of the probate process.

Frequently, people will have their bank accounts or securities placed in the name of themselves with one or more children or trustworthy friends as joint tenants with right of survivorship. In situations in which bills need to be paid, this type of arrangement is created sometimes as a matter of convenience.

Disadvantages

One important thing to know is that arrangements such as this can result in unwanted or unexpected situations.  Disagreements, often leading to litigation, can occur between parties including the original owner's estate and any joint tenants that survive.  Often, it is felt by those represented by the estate that the survivor's name could have been added for management reasons or out of convenience.  Other issues of concern include whether gift taxation is applicable, in cases when the inclusion of persons as joint tenants was intended to serve as a sort of gift.

You cannot leave your interest in any property you hold as a joint tenant to your heirs. When a joint tenant dies, his or her interest in the joint tenancy asset vests in the surviving joint tenant or tenants. In other words, if two people own real estate and hold title as joint tenants and one of them dies, the surviving joint tenant then owns 100 percent of the property. If a will has been drawn up by you or have a trust directing the distribution of your property at death to your loved ones, your estate plan could be partially or completely thwarted by a joint tenancy, inadvertently created, that allows for property to be passed to the remaining joint tenant as a result of local law, rather than as stated within the will or trust.

There are other drawbacks with holding property in this manner. For example, once you add someone to your deed, you both will share ownership rights to the property as well as subjecting the property to liability for each other's debts.

Fact Pattern:
Let's assume you add your daughter to the title of your real property as a joint tenant to avoid probate.

Scenario One
Your daughter loses her job and falls behind in her credit card payments. Your daughter's creditors sue her and obtain judgments. Judgments in California are good for 10 years and can be renewed up to 20 years. Even though you have paid for the house, after you added your daughter as a joint tenant, you exposed your house to liability for all of your daughter's debts, as well as all of your debts. A lien can be put on your house to pay your daughter's debts.

Scenario Two
Here let's say your daughter doesn't have debt problems, however, some years later, the relationship between you and your daughter starts deteriorating and you want to take her off the deed. You cannot remove her from the deed without her permission. In fact, in most cases you will not be able to sell the property without her permission.

Scenario Three
Here we will assume you pass away and, as planned, the property passes to your daughter without the need for probate. Now, unless your daughter does some advance estate planning, at will be necessary to initiate a probate proceeding to transfer the property to her heirs.

Scenario Four
Holding property as joint tenants doesn't provide for incapacity issues of a joint tenant like a trust does. Let's say your daughter becomes incapacitated. You decide it would be in both of your best interests to sell the property and move to a warmer climate. Except, because your daughter is incapacitated, she cannot sign ownership papers or convey her interest. This could prevent you from selling or renting the property unless a conservatorship is obtained through a lengthy and expensive court proceeding.

Estate and Gift Taxation of Property Held as Joint Tenants
Joint tenancy can be subject to wealth transfer tax on creation, on termination, during life and at death. The creation of the joint tenancy can be subject to gift tax if a gift was intended. However, adding a joint tenant to a bank account is not a gift until the added joint tenant withdraws funds from the account.

Whether or not a decedent's joint tenancy interests will be subject to estate tax at death depends on how the tenancy was created and with whom. Section 2040(a) of the IRS Code states that 100% of the full value of the jointly held property will be included in the estate of the decedent.

There are three exceptions to this inclusion rule:

  1. If the joint tenancy is between spouses, only ½ will be included in the estate of the first spouse to die (see Marital Deduction)
  2. If the joint tenant had contributed consideration for the acquisition of the property, that percentage will not be included in the decedent joint tenant's estate
  3. If the joint tenancy was created by gift, the percentage gifted will be included in the decedent joint tenant's estate. If the joint tenancy was created by gift to more than 2 joint tenants and no percentage of ownership was established, an equal share will be included.

If none of the three exceptions apply, the joint tenancy property's value may be taxed in the estates of both joint tenants. This occurs when the joint tenants are not spouses. Thus, if a brother and sister or parent and child hold property jointly, the entire value of such property will be includible in the estate of the first to die (unless the survivor can prove his contribution), and then in the estate of the survivor if he still owns the property at his death.

For example: Think of a fact scenario where a father transfers his home to his three children A, B and C as joint tenants and otherwise does not provide for a scheme of ownership interest. When A dies, 1/3 of the home will be included in A's gross estate. Now let's assume B dies. One-half of the estate will be included in B's gross estate. And finally, when C dies the entire estate will be included in C's gross estate. The inclusion of one piece of property over A, B and C's lives is over 188%. From a tax perspective, joint tenancy is not an attractive way to hold title.

Property owned by spouses as joint tenants or as tenants by the entirety can't be used for credit shelter bequests.

Unwanted property reassessment issues occur when certain transfers take place and joint tenants are added and removed. Joint tenancy is one of the most misunderstood manners in holding title to property and many attorneys highly discourage their clients from holding title as joint tenants.

Basis and Capital Gains Tax
To help understand gain on the sale of property, it is important to understand the concept of basis and stepped up basis. Basis is the value at which the asset was originally purchased. Stepped up basis is the readjustment of an appreciated asset's value for purposes of taxation upon inheritance. With a step-up in basis, the asset's value is determined to be the asset's higher market value upon receiving the inheritance, not the value at which the original party purchased the asset.

Simply put, if the property is inherited, the heir receives a basis in the inherited property equal to its date of death value. For example, if I purchased a property for $100,000 and it was worth $300,000 when I died, my beneficiary's basis in the property when they received it (at my death) would equal $300,000.

In addition to estate tax issues with joint tenancy property, there are capital gain tax issues inherent with how you own property. This is because the basis and step up in basis rule applies only to the inherited portion of property owned jointly with the deceased, but not the portion of jointly held property that you owned before receiving the entire property through inheritance.

EXAMPLES:

Basis Generally
If $40,000 was paid for by you for a home (and made no capital improvements) your basis in the home is $40,000. If the home is sold by you for more than the basis, the amount over basis (the value of the appreciation) will be a taxable gain. Let's assume years later, in 2008, you sell your home for $600,000. Your taxable capital gain is $560,000 (subject to the residence exclusion). On the other hand, if you died in 2008 still owning the property, your beneficiary would get a step-up in basis equal to the home's fair market value, in this case, $600,000.  If your beneficiary sold the home soon thereafter for $600,000, there would not be a taxable gain.

Basis holding property as Joint Tenants
Let's say you buy a residence with your partner as joint tenants for $40,000, both contributing $20,000 for the purchase price. When your partner passes away the residence has a fair market value of $600,000. Your partner's basis in the property at the date of death gets stepped up to $300,000 (1/2 of $600,000). However, your interest is not stepped up and remains at $20,000. The total basis in the property at the death of your partner is now $320,000 ($300,000 + $20,000). If you were to sell the property right then, your taxable capital gain would be $280,000. Now let's say you decide to hang onto the property for 2 years and when you sell it, the fair market price is $800,000. When you sell the property you realize a gain of $480,000 ($800,000 - $320,000 = $480,000).

Basis holding property as Community Property
Using the same figures as above, if the appreciated asset was held by a married couple as community property, the surviving spouse would get a step-up in the cost basis to the fair market value at the date of death of the other spouse. As both interests would get a step up in basis, there would not be a gain at date of death ($300,000 + $300,000 = $600,000). However, if the surviving spouse hangs onto the home for 2 years and sells it for $800,000, there would be a gain of $200,000 ($800,000 - $600,000 = $200,000). The gain may be excluded from your gross income if the sale qualifies for the Section 121 (see below) residence exclusion. A summary probate procedure would need to be initiated to transfer ownership to the surviving spouse.

Holding property as Community Property with Right of Survivorship
If the property is held by a married couple as community property with right of survivorship, both interests would get a step up in basis and there would not be a gain at the death of the first spouse. Transfer to the surviving spouse is accomplished by an affidavit filed with the recorder's office and a probate procedure to transfer ownership to the surviving spouse would not be necessary. However, absent planning, a probate would be necessary to transfer the property at the surviving spouse's death.

Internal Revenue Code Section 121 Exclusion of Gain From Sale of Principal Residence
Your gross income will not include the gain on the sale of property if the property sold was your principal residence at least two years out of the five years before the sale or exchange. The amount excluded will be limited to $250,000 for individuals and $500,000 for married couples. In most cases, sellers can only take advantage of the provision once during a two-year period.

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