Carryover Basis Complicates Planning / Settlement

I have been asked a lot of questions about the new carryover basis rules and what this means for someone who inherits property in 2010. Simply put, repeal of the federal estate tax that has taken effect in 2010 means that the stepped up basis that the inheritor would have received in 2009 and prior years is officially gone.

The good news is, that for most smaller estates, the practical effect of the change is non-existent. Moderate and larger estates, however, will now find additional taxes, and complications.

A stepped up basis means that the recipient of an inherited asset gets to increase the income tax basis of the asset to its date of death fair market value, which in turn is the basis used for calculating capital gains taxes when the inherited asset is sold. But not so now - instead for deaths occurring in 2010 an heir will receive the decedent's original basis in the inherited asset, which can be adjusted by the executor or personal representative using the new modified carryover basis rules. The personal representative call allocate additional basis to the property received by the beneficiary, in order to reduce the capital gain.

In 2009 and years prior, for example, if a beneficiary inherited a house that cost the decedent $500,000 but
on the date of the decedent's death the house had a fair market value of $2,000,000, then the beneficiary would have received a step up in the original cost from $500,000 to $2,000,000, and there would be no capital gains tax on a sale of the property for $2,000,000 or less. But in 2010, the beneficiary will inherit the house with the original basis of $500,000, which can be adjusted using the modified carryover basis rules. Under these rules, if the property is passing to someone other than a surviving spouse, the personal representative can increase the basis by up to $1,300,000, so in this example for a a non-spouse beneficiary, the allocation of additional basis can increase the basis to $1,550,000: $2500,000 original basis + $1,300,000 allowable basis increase = $1,800,000 modified carryover basis. Under the new carryover basis rules, then, the heir would pay taxes on the $200,000: $2,000,000 (sales price) - $1,800,000 (modified basis) = $200,000 (capital gain).

If the property is passing to the surviving spouse, then the spouse can increase the basis by up to an additional $3,000,000, so, in this example the surviving spouse can increase the basis to the full fair market value of $2,000,000, with basis left to spare! That means that the spouse will realize no taxable capital gain upon sale of the property. $2,000,000 (sales price) - $2,000,000 (modified basis) = 0. For tax purposes, “zero gain” is a good thing.

The loss of the step-up in basis also complicates the estate administration. With a step-up in basis, the original basis was irrelevant; whatever the basis was, it is stepped-up to the fair market value on the date of death. There is no need, therefore, to obtain proof of the original basis.

Now, under the modified carryover basis rules, if the value of the gain for all property in the estate exceeds $1,300,000, the executor or personal representative will need to first determine the basis of the property, and next, allocate additional basis, if necessary, to avoid capital gains taxes. Under IRS rules, if one cannot establish evidence of the basis of property, the basis is “zero” for the purposes of determining capital gain. This may seem a small thing, but it is not unusual for seniors to have lost evidence of the purchase price of stocks, and private business interests. Fortunately, at least in the State of Ohio, where there is a conveyance tax, there is usually evidence of the purchase price of real property, but the same cannot be said for real property purchased in all states, and there may be no evidence of interests in property which do not require filing a conveyance tax. Evidence of the purchase price of personal property, such as antiques, coins, or jewelry, can also be difficult to obtain.

There are also amendments to estate planning documents that should be considered for larger estates. Allocation formulas for "B" trusts (QTIP and Credit Shelter Trusts) should be reviewed given the elimination of the estate tax for the year 2010 (see my previous blog in this regard), and probably changed.  The new carryover basis rules leave numerous additional unanswered questions that properly drafted documents might answer, such as whether the personal representative must allocate basis to property equally, proportionally, or without regard to the impact upon a particular beneficiary’s ultimate share, and whether the personal representative can allocate basis to property which the personal representative is receiving, if he or she is also an heir of the estate.

Welcome to 2010!