Estates, Trusts & Gifts
If property is inherited or otherwise received from a decedent, how does the estate or its beneficiaries determine the basis acquired? Prior to 2010, the general rule was that property received from a decedent acquired a new basis equal to the fair market value (FMV) of the property at the date of the decedent’s death (or alternate valuation date, if applicable) (Sec. 1014; but for inapplicability after 2009, see Sec. 1014(e)). For property acquired from a decedent dying during 2010, a modified carryover basis regime will apply (Sec. 1022).
This new modified carryover basis regime is a direct result of the repeal of the estate and generation-skipping transfer (GST) taxes effective January 1, 2010. The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), included provisions resulting in the repeal of the estate and GST taxes for one year commencing January 1, 2010, along with the adoption of modified carryover basis for 2010. Although the leaders of Congress and the administration had indicated their intention to revise the law during 2009 so that the 2009 rates and exemptions and the step-up basis rules would apply during 2010, that did not happen. Thus, effective January 1, 2010, the estate tax and the GST tax are both repealed for one year. Some members of Congress have indicated a desire to retroactively impose the taxes and repeal modified carryover basis to January 1. There is uncertainty about whether a retroactive enactment of these estate and GST taxes would be constitutional.
Generally, subject to certain statutory permitted basis adjustments by the executor, the modified carryover basis regime will provide the estate or beneficiary receiving property from a decedent with a basis equal to the lesser of the decedent’s basis or the property’s FMV as of the date of death (Sec. 1022(a)). The modified carryover basis regime will place a huge burden on executors, trustees of a decedent’s revocable trusts, beneficiaries, heirs, and their advisers to determine the basis of assets acquired from a decedent, especially if the estate has built-in gain in excess of $1.3 million.
The general rule is that property acquired from a decedent dying after December 31, 2009, should be treated as if the property had been acquired by gift, and the basis of the person acquiring the property should equal the lesser of the adjusted basis of the decedent’s property or the FMV of the property at the date of the decedent’s death (Sec. 1022(a)). With the repeal of the estate tax, the step-up in basis of the decedent’s assets has been lost. The decedent’s assets will step down if they have a value less than their basis, but they will no longer step up.
For the modified carryover basis rules to apply, the property must have been “property acquired from the decedent” (Sec. 1022(a)(1)). Such property includes the following:
- Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent;
- Property transferred by the decedent during his or her lifetime to a qualified revocable trust (as defined in Sec. 645(b)(1));
- Property transferred by the decedent during his or her lifetime to any other trust for which the decedent reserved the right to make any change in the enjoyment thereof through the exercise of the power to alter, amend, or terminate the trust; and
- Any other property passing from the decedent by reason of death to the extent that the property passed without consideration (Sec. 1022(e)).
Clearly, any property passing through the decedent’s estate will fall within the modified carryover basis regime. Assets transferred during lifetime by the decedent into the typical revocable living trust will likewise be subject to the modified carryover basis regime because such a trust will qualify as a qualified revocable trust. A qualified revocable trust is any trust (or portion thereof) that on the date of the decedent’s death was treated as owned by the decedent under Sec. 676 by reason of a power held by the decedent to revest in the decedent title to the property of the trust (determined without regard to Sec. 672(e)) (Sec. 645(b)(1) and Regs. Sec. 1.645-1(b)(1)).
Sec. 672(e) attributes powers or interests held by a spouse to the grantor, and therefore the power to revoke held by a spouse will not be attributed to the decedent for purposes of the modified carryover basis regime. The trust would still be considered a qualified revocable trust even if the decedent had to have the consent or approval of a nonadverse party or the decedent’s spouse. (A nonadverse party is any party who is not an adverse party (Sec. 672(b)). An adverse party is any person having a substantial beneficial interest in the trust who would be adversely affected by the exercise or nonexercise of the power that he or she possesses respecting the trust (Sec. 672(a)).) A trust that was treated as owned by the decedent under Sec. 676 solely by reason of the power held by a nonadverse party or by reason of a power held by the decedent’s spouse is not a qualified revocable trust. Property received by operation of law through joint tenancy with right of survivorship or tenants by the entirety should also be subject to the modified carryover basis regime as property passing without consideration from the decedent by reason of death.
A major distinction between the modified carryover basis regime and the prior step-up basis regime set forth in Sec. 1014 is that the phrase “property acquired from the decedent” under Sec. 1014 included property required to be included in determining the value of the decedent’s gross estate under the estate tax (Sec. 1014(b)(9)). Since there is no federal estate tax during 2010, the concept of allowing a change in basis for assets included in the gross estate simply cannot apply.
Executor May Allocate Basis Adjustments to Increase Basis
An executor may allocate certain basis adjustments on a return to be filed with the IRS under Sec. 6018 (Sec. 1022(d)(3)(A)). As of mid-February 2010, the IRS had yet to develop the return required by Sec. 6018. The information to be supplied to the IRS on this return includes:
- The name and tax identification number (TIN) of the recipient of the decedent’s property;
- An accurate description of the property;
- The adjusted basis of the property in the hands of the decedent and its FMV at the time of death;
- The decedent’s holding period for the property;
- Sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income;
- The amount of basis increase allocated to the property by the executor; and
- Other information required by Treasury (Sec. 6018(c)).
The return required by Sec. 6018 is to be filed with the decedent’s income tax return for the year of the decedent’s death or a later date specified in regulations prescribed by Treasury (Sec. 6075(a)). Given that the information required by this return will in many cases be more than the information required to file an estate tax return, it would seem prudent for Treasury to set a due date similar to the due date for estate tax returns, which with extensions could be filed as late as 15 months after the date of the decedent’s death.
In general, the executor can allocate $1.3 million (aggregate basis increase) on an asset-by-asset basis among the decedent’s eligible built-in gain assets (S. Rep’t No. 30, 107th Cong., 1st Sess. (2001), relating to EGTRRA). The allocation by the executor cannot increase the basis of any interest in property acquired from the decedent above the FMV of the interest in the property as of the date of the decedent’s death (Sec. 1022(d)(2)). The $1.3 million allocation amount is also increased by the sum of (1) the amount of any capital loss carryover, (2) the amount of any net operating loss carryover that would, but for the decedent’s death, be carried from the decedent’s last tax year to a later tax year of the decedent; and (3) the amount of any losses that would have been allowable under Sec. 165 if the property acquired from the decedent had been sold at FMV immediately before the decedent’s death (Sec. 1022(b)(2)(C)). In the case of a decedent nonresident who is not a citizen of the United States, the aggregate basis increase is limited to $60,000, and no increase results from capital loss carryovers, net operating loss carryovers, or Sec. 165 built-in gains (Sec. 1022(b)(3)).
As a practical matter, this basis adjustment provision allows the step-up basis rules to continue to apply to decedents’ estates with built-in gain of $1.3 million or less. In addition, even though the basis of depreciated assets is stepped down to FMV at the time of the decedent’s death, the ability to allocate the Sec. 165 built-in losses among the decedent’s appreciated assets causes the “lost basis” to be shifted to other appreciated assets of the decedent.
If the decedent is survived by a spouse, the executor may allocate an additional $3 million (aggregate spousal property basis increase) to:
- Any interest in property that the decedent’s surviving spouse acquires from the decedent (outright transfer property); and
- Any qualified terminable interest property (QTIP) (Sec. 1022(c)).
A QTIP has rules similar to those applicable to the marital trust that would have qualified for the estate tax marital deduction as provided in Sec. 2056(b)(7), except no election is required. A QTIP for these purposes is property that passes from the decedent, and the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property. No person has the power to appoint any part of the property to any person other than the surviving spouse. A power of appointment exercisable only at or after the death of the surviving spouse is acceptable (Sec. 1022(c)(5)). Strangely, because of the limitation on powers of appointment, a trust designed to qualify for the estate tax marital deduction as provided in Sec. 2056(b)(5) will most likely not qualify for the basis adjustment because the surviving spouse will hold a general power of appointment, causing the trust to fail to qualify as a QTIP.
The net effect of the aggregate basis increase and the aggregate spousal property basis increase is that for estates with a surviving spouse receiving either outright or in a QTIP up to $3 million of built-in gain assets, the total basis adjustment the executor may allocate is $4.3 million. The decedent’s built-in gain would need to exceed $4.3 million before the modified carryover basis rules would have an impact. Often, however, attorneys have drafted wills or revocable living trusts for couples with formula provisions that, due to the estate tax repeal, may cause the decedent’s estate to be distributed entirely to a trust that will benefit the spouse and the decedent’s children. Such a trust will not qualify as a QTIP, so the $3 million aggregate spousal property basis increase will be lost. (A QTIP must be solely for the benefit of the surviving spouse.) Couples with wills or revocable trusts with such formula clauses should consult with their attorney to consider revising the formula provision to better account for the $3 million spousal property basis increase. Special care must be taken in drafting such revisions because the adjustment relates to the amount of the built-in gain, not the FMV of the assets. For example, an asset worth $100 million might have a built-in gain of only $3 million. Should the executor have the power to allocate the $100 million to a QTIP to allow for allocation of the aggregate spousal property basis increase?
Similar to the step-up basis rules for pre-2010 deaths, those decedents living in a community property state are at an advantage under the modified carryover basis regime. Spouses owning community property under state law are considered to own an undivided one-half interest in the property. For purposes of the modified carryover basis regime, however, the surviving spouse’s one-half interest is deemed to have been acquired from the deceased spouse (Sec. 1022(d)(1)(B)(iv)). This rule for community property means that if the couple has community property with built-in gain of at least $6 million, the executor should be able to take advantage of both the aggregate basis increase of $1.3 million and the aggregate spousal property basis increase of $3 million, regardless of who receives the deceased spouse’s property.
For example, if a husband and wife own appreciated community property with a built-in gain of $10 million and the husband dies with a will containing a formula bequest of his one-half of the community property to a trust for his wife and children (not a QTIP because the trust has beneficiaries other than the spouse), the executor for the husband’s estate will be able to allocate the aggregate spousal property basis increase of $3 million even though none of the decedent’s property would have qualified. The executor would allocate a spousal property basis increase of $3 million to the surviving spouse’s one-half of the community property, and the remaining $1.3 million of aggregate basis adjustment could be allocated to property passing to the trust for the benefit of the spouse and children.
Property Owned by the Decedent
For property to be eligible for the basis adjustments by the executor, it must be property owned by the decedent at the time of death (Sec. 1022(d)(1)(A)). For property that was owned by the decedent and another person as joint tenants with right of survivorship or tenants by the entirety, if the only such other person is the surviving spouse, the decedent will be treated as the owner of only 50% of the property. If there are other tenants besides the surviving spouse and the decedent has furnished consideration for the acquisition of the property, the decedent will be treated as the owner to the extent of the portion of the property that is proportionate to the consideration provided. If there are other tenants besides the surviving spouse and the property has been acquired by gift, bequest, devise, or inheritance by the decedent and others, and their interests are not otherwise specified or fixed by law, the decedent will be treated as the owner to the extent of the value of a fractional part to be determined by dividing the value of the property by the number of joint tenants with right of survivorship (Sec. 1022(d)(1)(B)(i)).
The decedent will be treated as owning property transferred by the decedent during life to a qualified revocable trust as defined in Sec. 645(b)(1) (Sec. 1022(d)(1)(B)(ii)). As discussed above, property that represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws will be treated for these purposes as owned by, and acquired from, the decedent if at least one-half of the whole of the community interest in the property is treated as owned by, and acquired from, the decedent.
The decedent will not be treated as owning any property by reason of holding a power of appointment for such property (Sec. 1022(d)(1)(B)(iii)).
Property acquired by the decedent (other than from a spouse) by gift or by lifetime transfer for less than adequate and full consideration in money or money’s worth during the three-year period ending on the date of the decedent’s death will not be eligible for basis adjustment by the executor (Sec. 1022(d)(1)(C)(i)). Gifts from the decedent’s spouse within three years of death will be eligible for the basis adjustment by an executor unless, during the three-year period ending on the date of the decedent’s death, the gifting spouse acquired the property in whole or in part by gift or by lifetime transfer for less than adequate and full consideration in money or money’s worth (Sec. 1022(d)(1)(C)(ii)).
Similar to the pre-2010 step-up in basis rules, the following stock of certain entities will not qualify for the basis adjustment by an executor:
- Stock or securities of a foreign personal holding company;
- Stock of a domestic international sales corporation (DISC) or a former DISC;
- Stock of a foreign investment company; or
- Stock of a passive foreign investment company, unless such company is a qualified electing fund (as defined in Sec. 1295) with respect to the decedent (Sec. 1022(d)(1)(D)).
The modified carryover basis regime of Sec. 1022 does not apply to property that constitutes a right to receive an item of income in respect of the decedent under Sec. 691 (Sec. 1022(f)). This exception is consistent with the rules that applied to the step-up basis rules prior to 2010. In general, the income in respect of decedent rules prevent a change in basis with respect to the decedent’s assets that would have generated ordinary income during the decedent’s lifetime.
Liabilities in Excess of Basis
In determining whether gain is recognized on the acquisition of the decedent’s assets (either from the decedent or from the decedent’s estate), liabilities in excess of basis will be disregarded when the assets are acquired by either the decedent’s estate or any beneficiary other than a tax-exempt beneficiary (Sec. 1022(g)(1)). A tax-exempt beneficiary is defined as:
- The United States, any state or political subdivision thereof, any possession of the United States, any Indian tribal government, or any agency or instrumentality of any of the foregoing;
- An organization (other than a cooperative described in Sec. 521) that is exempt from tax imposed by chapter 1 (i.e., normal income taxes and surtaxes);
- Any foreign person or entity (within the meaning of Sec. 168(h)(2)); and
- To the extent provided in regulations, any person to whom property is transferred for the principal purpose of tax avoidance (Sec. 1022(g)(2)).
For these reasons, when an executor is planning distributions of estate assets to charities or foreign persons, when possible, the executor may want to select those assets that do not have liabilities in excess of basis. Revised Sec. 684 for 2010 will cause a U.S. estate to recognize gain when distributing appreciated assets to nonresident aliens (Sec. 684(a)). Lifetime transfers will not be subject to the deemed sale rule (Sec. 684(b)).
Sunset of Modified Carryover Basis
For decedents dying after December 31, 2010, the tax law is to be applied and administered as if the provisions and amendments of EGTRRA “had never been enacted” (EGTRRA §901(b)). For this reason, the modified carryover basis rules will cease to apply after 2010. The implications of the sunset provision in the context of the modified carryover basis regime are uncertain. One possible interpretation is that even if a decedent dies during 2010, the step-up basis rules of Sec. 1014 will apply for sales or exchanges after 2010. Treasury and ultimately the courts will need to provide guidance on the proper interpretation of the sunset provision.
The modified carryover basis regime became effective on January 1, 2010, and is effective for one year. The rules to implement under the regime are very complex. The impact of the modified basis regime will be greater than the estate tax regime in 2009 because the exemption for 2009 estates for estate tax purposes was $3.5 million, and the exemption against built-in gain without application of the spousal adjustment is limited to $1.3 million. Furthermore, the burden on executors and their advisers to gather the necessary information to comply, especially finding the basis of the decedent in certain assets, will be significant. Some members of Congress have indicated a desire to repeal the modified carryover basis rules retroactively to January 1, 2010. Tax advisers and their clients will have their work cut out for them if that does not happen.
Editor: Kevin D. Anderson, CPA, J.D.
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.