Joint Property - a trap for the unwary which may be a costly "mistake"

If you and your spouse have assets (including insurance, pensions, IRA's, etc.) with a total value in excess of $3.5 million, or if you have a substantial amount of property in "joint name," then your heirs may be at risk.  The next generation may owe Estate and/or Income Tax at rates approaching 50%, which can be easily avoided with proper planning.  The Federal Estate Tax may or may not become history after 2009.  The smart money is betting that it will continue with the current individual exemption of $3.5 million.

A.  The "Basics"

All plans to minimize Federal Estate Taxes revolve around a few basic rules:

• All property that passes from you to your spouse is shielded from the Federal Estate Tax by the Marital Deduction.
• Every estate is currently entitled to an exemption of $3.5 million from the Federal Estate Tax.
• Property you inherit comes to you with a new income tax basis, equal to its value at the date of the decedent's death.
• Where property has been held in a married couple's joint name ("with right of survivorship" or "by the entirety"), only half of its value is deemed to have been inherited by the survivor and acquires a new basis (an exception exists for property acquired prior to 1977).

The $3.5 million exemption makes it possible, with some planning, for a married couple to leave $7 million free of Federal Estate Tax to their beneficiaries. Yet, without proper planning, substantially smaller estates can generate substantial tax.  Assume that John and Mary have a combined estate of $5 million, all of which is in John's name.  John leaves his entire $5 million estate to Mary, his wife, who, thanks to the Marital Deduction, takes it free of Federal Estate Taxes.  The downside: when Mary dies and leaves the property to her children, they face Federal Estate Taxes shielded only by the $3.5 million exemption, with the balance exposed to rates that run up to 46%.  Mary's estate could owe approximately $700,000 in Federal Estate Tax.  

The above example illustrates an important point.  It is possible for a married couple to shield up to $7 million.  However, without proper planning, combined estates in excess of $3.5 million, even though not more than $7 million, can cost your heirs substantial Federal Estate Taxes.  Planning is required for all combined estates over $3.5 million.

With proper planning, the Federal Estate Tax in the example above could have been reduced to zero.  John could leave $3.5 million to a "Bypass Trust" that would pay Mary the income (plus as much of the principal as she might need to maintain her accustomed lifestyle) during her lifetime, after which any remaining assets of the trust would be paid to the children. The balance of John's estate ($1.5 million) could be left to Mary outright. No tax would be due from John's estate because the Marital Deduction shields the $1.5 million left to Mary, and the exemption covers the $3.5 million left to the Bypass Trust.

The payoff on this plan is realized on Mary's death, when the Bypass Trust passes directly to the children.  The $3.5 million Bypass Trust is not considered part of her estate.  Mary's estate amounts to $1.5 million, which passes free of Federal Estate Tax because of her own Federal Estate Tax exemption.  Even if the $1.5 million that she received from her husband's estate appreciates in value before her death, it will be exempt up to $3.5 million.  The $3.5 million in the Bypass Trust plus any appreciation will pass free of Federal Estate Taxes to the children.  The tax savings is approximately $700,000.

B.  Joint Property  

Many couples believe that they have accomplished their "Estate Planning" by keeping all, or a significant portion of, their property in joint name. As a form of ownership, it is simple, and sometimes lessens the expenses of probate and estate administration.  However, there are certain circumstances where holding property in joint name can be a costly mistake from both an Estate Tax and income tax perspective.

From an Estate Tax perspective, it is important to understand that joint property cannot be distributed to a Bypass Trust without the use of a Qualified Disclaimer, which can be complicated.  Since the whole estate goes to the surviving spouse, Federal Estate Taxes do not enter the picture on death of the first spouse. However, this type of "Estate Planning" can be very costly.  The "joint property estate plan" passes the Estate Tax problem on to be reckoned with at the death of the second spouse.  Mary's estate will include a total of $5 million - and there is no Bypass Trust.  The children now owe several hundred thousand dollars of Federal Estate Taxes.  

Joint property also has income tax consequences.  Another opportunity forfeited in this example involves the basis step-up for inherited property.. In certain cases the bulk of a couple's property should be owned by the spouse who is likely to predecease the other; i.e., not in joint name.  Property held by the surviving joint tenant does not get a step-up in basis for income tax purposes.  Since any amount of property can be transferred between husband and wife free of gift tax, it is a simple matter to allocate their holdings before the first spouse dies.  With proper planning, not only will the assets receive a stepped up basis, but also the Federal Estate Taxes on both spouses' estates can be reduced to zero.

Beware of dying with "losses".  The basis of inherited property (its fair market value at the date of death) is not necessarily "stepped up".  Paper losses on securities held by the decedent will mean a reduced basis to the new owner, wiping out any income tax benefit the decedent could have had by realizing the loss. So take your losses - don't leave them to your heirs.

As to "avoiding probate" in New Jersey, probate is neither difficult nor expensive.  The cost of filing the probate pleadings is under $500.  The "extra" costs of administration may be zero, depending on the nature of your assets and who is named as fiduciary.

Proper planning does not need to be difficult, complicated or expensive. It can save your heirs substantial amounts of both Federal Estate Tax and income tax.  For more information or to discuss Wills, Joint Property or Estate Planning, call Phil Perskie, Rick Mairone or Alex Barrera.