You probably heard that there is no federal estate tax in 2010 (at least so far). But did you hear about carry-over basis?
The "basis" of a piece of property is generally the purchase price of that property and is used to calculate taxable gain (or loss) when property is sold. The basis may be increased by improvement to the property or decreased by depreciation. In the case of stocks and bonds, the basis simply equals the purchase price, while with real estate the basis equals the purchase price plus the value of all capital improvements. The greater the increase in value of property, the greater the taxable gain when sold.
Prior to 2010, the basis of property acquired from a decedent was stepped up (or stepped down) to its date of death value. The basis step-up for property acquired from a decedent allowed individuals to transfer appreciated property to family members and others at death without the transferor, recipient or anyone else having to pay income tax on the pre-death appreciation. The policy behind the step-up was that it would be unfair to subject pre-death appreciation in assets to estate tax and then also to income tax if and when the heir later sells.
For decedents dying after December 31, 2009, the basis of property acquired from the decedent will no longer get a "step-up" in basis to date of death value. It will be replaced by a "modified carry-over basis." In general, for decedents dying in 2010, the basis of property acquired from the decedent will be the lower of the fair market value on the date of the decedent's death or the adjusted basis of the property immediately before the death of the decedent. These basis rules are contained Section 1022 of the Internal Revenue Code.
Carry-over basis generally means the basis of inherited property remains the same as it was for the deceased owner; which potentially increases the amount of gain (and income tax) when the property is sold. However, if the decedent's basis was higher than date of death value, the decedent's basis does not carry-over - it is reduced to date of death value. That is why it is called "modified" carry over basis.
What a mess. That means that in order to determine the basis, the executor will have to research the historical basis of assets - which is going to be extremely difficult since many people do not have records showing the acquisition cost of assets and the executor must value all assets as of the date of death. The basis in the hands of the beneficiary will be the lower of the two values.
Finding the historical basis of assets will be challenging. For example, stock with dividends reinvested gets a basis adjustment each time the dividends are reinvested. Basis changes when companies have been spun off from parent companies. For real estate, basis includes not only the initial acquisition cost, but also the cost of certain capital improvements. Many people are not aware of the basis in their property; and after their deaths, determining basis can be next to impossible.
There are two exceptions to the modified carryover basis rules:
First, each decedent's estate will get a $1.3 million increase in basis which can be allocated among assets by the executor. The $1.3 million is increased by (1) the amount of any capital loss carryover, and net operating loss carryover which would, but for the decedent's death, be carried from the last tax year to a later tax year of the decedent, plus (2) the sum of the amount of certain types of losses that would have been allowable to the decedent, if the property acquired from the decedent had been sold at fair market value immediately before the decedent's death. No increase is allowed for appreciated property acquired by the decedent within three years of death for which a gift tax return was required to be filed.
Second, there is an additional $3 million increase in basis for assets passing to the decedent's surviving spouse either outright or in a qualified terminable interest in property(QTIP) trust. You should have your plan reviewed to make sure that property left to the surviving spouse is eligible for the $3 million spousal property basis increase. Marital trusts that are not QTIP's will not qualify.
There will be a return required. Of course, it has yet to be made available by the IRS. It will be an informational return to report the basis and show to which assets the additional step-ups ($1.3 and $3 million) were allocated. A return must be filed for 2010 decedents who are U.S. citizens or residents whose gross estate exceeds $1.3 million plus the decedent's unused built-in losses and loss carry-overs; or non-citizen, non-residents whose gross U.S. property exceeds $60,000.