IRS Carry-Over Basis Rules for 2010

New Basis Rules On Death

Until January 1, 2010, people were able to avoid capital gains tax at the time of their death because §1014 of the Internal Revenue Code had provided that on the death of an individual the tax basis in the property was "stepped up" (or adjusted down) to the fair market value of the property at the date of death of the individual. Effectively, if such property had increased in value during the decedent's lifetime, the unrealized gain permanently escaped income taxation by either the decedent's estate or the person acquiring such property. In other words, if a person owned a $1,000,000 house with a tax basis of $200,000, the person who inherited the property would own a property with a $1,000,000 tax basis. If such person sold the property for $1,000,000, there would be no income tax as a result of the sale. Thus, the appreciation on the property would have permanently escaped income tax.

Effective January 1, 2010, the step-up basis rules were terminated and replaced by a carry-over basis. The carry-over basis regime is referred to as "modified carry-over basis" because the new rules allow certain "adjustments" to basis on death.

Carryover basis rules are now applicable and there is only a limited allowable step-up in basis in 2010 and beyond. Internal Revenue Code §1022.

a. There are 2 modifications to the carryover basis rule - the Executor can increase the basis up to $1.3 million for gifts to non-spouses and an additional $3 million for gifts to surviving spouses or QTIP Trusts for a surviving spouse.

b. It is possible to make a gift to a surviving spouse with built-in capital gain of as much as $4.3 million with a step-up in basis. See illustrations below.

c. Please note you cannot adjust the basis upward above the fair market value on the date of death. In fact, if the date of death fair market value is lower than the basis, the date of death value must be used.

d. Only one-half of property jointly owned with rights of survivorship between the decedent and his spouse is treated as basis adjustment property. §1022(d)(1)(B)(i)(l).

e. Property over which the decedent held any power of appointment is not basis adjustment property. Hence, if beneficiary of a trust who has been granted a general power of appointment in the trust has a very short life expectancy, one should consider exercising the power to withdraw appreciated property from trust in 2010, thus making it available for basis adjustment on his or her death.

f. A $10,000 penalty is imposed on an executor who fails to file the carryover basis return on time. §6716.

ILLUSTRATIONS:

EXAMPLE: Mary dies in 2010 with appreciated property with a fair market value of $5 million on the date of death and for which her basis is $3 million. Her beneficiaries' basis in the property remains at $3 million and is not stepped up to $5 million as would have occurred before 2010. If executor elects, $1.3million could be added to the basis, or if the beneficiary is her spouse, the entire $5 million value will be stepped up.

EXAMPLE: George dies in 2010 with depreciated property having a fair market value of $2 million and for which his basis is $3 million. His beneficiaries' basis in the property is $2 million.

EXAMPLE: Joan dies in 2010 owning only one asset, her farm, Fairhaven. Joan's basis in Fairhaven was $9 million. The fair market value of Fairhaven at Joan's death is $10 million. Joan leaves Fairhaven to her son, Bill. Joan's executor allocates $1 million of the $1.3 million basis adjustment to Fairhaven. Bill's basis in Fairhaven as a result of special adjustment is $10 million.

EXAMPLE: Harry dies in 2010 owning stock in a closely held corporation, XYZ,Inc, and a tract of land, Blackacre, both of which pass to his daughter, Molly. The XYZ stock is valued at zero and Blackacre is valued at $3 million. Harry's basis in the XYZ stock was $1 million and his basis in Blackacre was $400,000. Harry's executor could allocate the $1.3 million Special Basis Adjustment plus the additional basis increase caused by the built-in loss of $1 million for the stock of XYZ stock to Blackacre. If Molly subsequently sold Blackacre for $3 million, she would have a $300,000 gain ($3 million sales price less basis of $2.7 million).

Please contact Mette, Evans & Woodside if you have any questions.