Using Joint Accounts for Estate Planning in Michigan: The Capital Gains Tax Trap

A joint account can be an essential estate planning vehicle, particularly when they are held as a joint tenancy with rights of survivorship. This tool can help avoid the public probate process and provide the surviving owner with immediate access to the funds. But despite the simplicity and convenience of a joint account, there are several tax traps to be aware of. The capital gains tax implications and the step up in basis can result in unexpected liabilities — this is why it is crucial for each owner to document their contributions into the account. 

Why Joint Accounts Are Advantageous

A joint account refers to a bank account or investment account that is owned by two or more individuals. All individuals named on the account have equal rights to the funds and can access them. Typically, when one owner of the account passes away, their share is transferred to the remaining owners. 

There are several reasons people are drawn to joint accounts when it comes to estate planning, including: 

• Probate avoidance — Assets in a joint account automatically pass to the surviving owners of the account and bypass the probate process.
• Reduced expenses — Since joint accounts bypass the probate process, this can lead to fewer expenses.
• Simplicity — Joint accounts are straightforward and simple to set up. There is no need to create complex trusts or draft additional legal documents with a joint account.
• Ease of management — Joint accounts are easy to manage during the lifetime of the owners. They can ensure transparency and streamline the process of managing joint finances.
• Immediate access — The survivors on the account can access funds without delay, which can be critical for paying expenses after death. 

It’s important to keep in mind that the benefits of a joint account can be outweighed by the tax consequences if the details regarding ownership and contributions are not properly documented. 

What is the Step Up in Basis?

Under federal law, when someone passes away, the basis of property they owned is “stepped up” to its fair market value at the date of death. This means that if the property is later sold, capital gains tax is only owed on the appreciation after the decedent’s death — rather than on the entire gain since the original acquisition. The step up in basis can significantly reduce capital gains tax that would otherwise be owed when an inherited asset is sold.

How Does the Step Up in Basis Impact Joint Accounts?

In Michigan, the surviving spouse generally receives a step up in basis for one-half of a joint account, regardless of who contributed the funds. For a non-spouse on a joint account, the surviving owner receives a step up only for the portion of the account that is attributable to the decedent’s contribution. If the survivor did not contribute, the entire account receives a step up. If both contributed, the survivor must prove their share to avoid full inclusion. 

Why Documenting Contributions into a Joint Account Matters

The IRS and Michigan law require that the step up in basis for property held in joint accounts be allocated according to each owner’s contribution. For example, if a parent adds a child to a stock account as a joint tenant, but the child never contributed funds, the entire account is included in the parent’s estate, and the child receives a full step up in basis. However, if both parties contributed, the survivor must be able to prove their own contributions to the account. 

If a party cannot prove their contributions, the IRS may treat the entire account as if it is owned by the decedent, resulting in a full step up in basis. This can lead to disputes with the estate or other heirs, as well as IRS scrutiny. Other issues that can stem from a party’s inability to prove their contributions can include: 

• IRS challenges: If the IRS determines a survivor on the account contributed funds but cannot prove it, the survivor may face unexpected capital gains tax liability when they sell the asset.
• Estate disputes: Other heirs may challenge the survivor’s claim to the account if they lack documentation.
• Gift tax issues: Adding a non-spouse as a joint tenant on an account is considered a gift, which may come with its own tax consequences. 

It’s key to keep clear records of who contributed what to the joint account. Without proper documentation, parties may face unexpected tax bills or legal disputes. 

Additional Non-Tax Pitfalls of Using Joint Ownership in Estate Planning

In addition to the tax consequences, there are non-tax pitfalls that should be noted when it comes to using joint ownership in estate planning — including loss of control. Adding another person as a joint owner gives them immediate and equal access to the account or property. This means the joint owner can withdraw funds or sell assets without the original owner’s consent, potentially leading to misuse or depletion of assets.

Other non-tax pitfalls of using joint ownership in estate planning can include the following:

• Exposure to creditors — Assets held in joint accounts are subject to the creditors of all joint owners. This means that if a joint owner is sued or has outstanding debts, the jointly held assets may be at risk of being seized to satisfy those obligations.
• Unintended disinheritance — Joint ownership overrides the terms of a last will and testament. Upon the death of one owner, the asset passes automatically to the surviving joint owner. This can result in unintentionally disinheriting other intended beneficiaries.
• Medicaid eligibility issues — Transferring assets into joint ownership may be considered a transfer for less than fair market value. This can potentially affect eligibility for Medicaid and trigger a penalty period for long-term care benefits.
• Family disputes — The use of joint accounts can lead to disputes among heirs, especially if other family members believe the joint owner was added for convenience rather than as a true beneficiary. Conflicts can also arise if the arrangement is not clearly documented.
• Loss of step-up in basis for non-spouse joint owners — While this is related to tax, it is also a practical pitfall: non-spouse joint owners may not receive a full step-up in basis, leading to confusion and potential disputes over asset valuation and inheritance.
• Incapacity complications — If one joint owner becomes incapacitated, the other owner may face legal hurdles in managing or disposing of the jointly held property. These complications commonly arise in situations where the incapacitated owner’s consent is required for certain transactions.

These additional pitfalls highlight the importance of carefully considering the use of joint ownership as an estate planning strategy, and ensuring that all potential consequences are fully understood and documented.

Contact an Experienced Estate Planning Attorney

While joint accounts can be a useful estate planning tool in Michigan, they come with hidden risks — especially when it comes to the step up in basis and capital gains tax. It’s vital to have a knowledgeable estate planning attorney by your side who can best advise you regarding the tax implications. To learn more about incorporating tax planning into your estate plan, contact us today. Our team of attorneys is dedicated to guiding individuals and families through the estate planning process and providing the legal help they need.