Joint purchases
How a simple estate planning tool can save a lot of taxes

Estate planning seems to get more complicated all the time. But there are still a few techniques available that are straightforward and easy to implement — and produce significant tax savings. One such strategy is the joint purchase, also known as a split purchase.

Timing is everything

The joint purchase technique is based on the concept that property can be divided not only into pieces, but also over time. One person (typically of an older generation) buys a current interest in the property and the other person (typically of a younger generation) buys the remainder interest.

A remainder interest is simply the right to enjoy the property after the current interest ends. If the current interest is a life interest, the remainder interest begins when the owner of the current interest dies.

Joint purchases offer several advantages. The older owner enjoys the property for life and his or her purchase price is reduced by the value of the remainder interest. The younger owner pays only a fraction of the property’s current value and receives the entire property — including any appreciation in its value — when the older owner dies.

Best of all, if both owners pay fair market value for their respective interests, the transfer from one generation to the next should be free of gift and estate taxes. The relative values of the life and remainder interests are determined using IRS tables that take into account the age of the life-interest holder and the applicable federal rate (the “Section 7520 rate”), which is set monthly by the federal government.

Family matters

At one time, the joint purchase was a popular way for parents to leave all types of property to their children — from securities to rental real estate — without transfer taxes. But in 1990, Congress, concerned about the potential for abuse, eliminated the tax advantages for most joint purchases.

Internal Revenue Code Sec. 2702 provides that, when members of the same family acquire a split interest in property, the owner of the current interest is treated as if he or she acquired the entire property and then transferred it to the owner of the remainder interest. In other words, the entire purchase price is treated as a taxable gift.

But there’s an exception for a joint purchase of a home. As long as the owner of the current interest uses the property as his or her primary residence, the transaction is exempt from gift tax.
Let’s look at an example. Allan, age 55, jointly purchases a new home with his daughter, Lauren. The price is $1 million and the Sec. 7520 rate at the time of the purchase is 6%. Under IRS tables, Allan pays $710,750 for a life interest and Lauren pays $289,250 for the remainder interest.

When Allan dies 20 years later, the property, now valued at $3.5 million, passes to Lauren tax free. Assuming a 45% marginal estate tax rate, transferring the property outside of Allan’s estate saves more than $1.5 million in taxes.

The drawbacks

Like many estate planning vehicles, joint purchases have disadvantages. The younger owner must buy the remainder interest with his or her own funds. Also, while the tax basis of inherited property is “stepped up” to its date-of-death value, a remainder interest holder’s basis is equal to his or her purchase price. In our example, if Lauren were to sell the property after Allan’s death, she would realize a capital gain of more than $3.2 million.

But, in most cases, the estate tax savings far outweighs any capital gains tax liability. That’s because the highest capital gains rate is currently 15% and the marginal estate tax rate is 45%. So, the tax due on a $3.2 million long-term gain is $480,000, while the estate tax on the $3.5 million of value is $1.575 million. (Keep in mind that this example doesn’t address state taxes.) Plus, the capital gains tax is due only if Lauren sells the property; the estate tax is due by virtue of Allan’s death.

Enlist tools at your disposal

For purposes of Sec. 2702, “family members” are limited to your spouse, your descendants and your descendants’ spouses. So a joint purchase can be a remarkably effective way to transfer virtually any type of property — not just a home — to a niece or nephew, a domestic partner or anyone else who doesn’t fall under the family member definition. Before adding the joint purchase tool to your estate planning arsenal, be sure to consider its pros and cons. •