2010 was a very interesting year from the perspective of estate taxes: it was the only year in which the estate tax was completely repealed. The IRS has just gotten around to finalizing regulations on how to value the estates of people who died in 2010.
In 2010, with no estate tax in place, decedents’ estates were required to apply a “carryover basis” for assets passing through the estate. This means that recipients of property from estates received the adjusted basis of the decedent, which could result in the taxation of gain on those assets when the beneficiaries sell or dispose of estate assets. Current law provides a stepped-up basis of the fair market value at the date of death, a rule that essentially prevents income taxation of appreciated estate assets.
The final regulations are contained in Treasury Decision 9811 and not only cover the basics, but also address issues such as recapture on leased property, basis issues relating to recognition of gain on transfers to foreign trusts, and recapture of depreciation on tangible personal property.
Why Does 2010 Still Matter? Trump’s Tax Plan
Under the 2010 carryover basis rules, beneficiaries of a decedent receive a basis equal to the lesser of the decedent’s adjusted basis or the fair market value of the property on the date of the decedent’s death. In other words, property acquired from a decedent is treated as if the property had been acquired by gift.
These rules were repealed and the estate tax was reinstated in 2011, but there are two reasons why they still matter going forward. First, the basis determination continues to be relevant until all property from those 2010 estates has been sold or disposed of. Second, we may see a revival of the carryover basis rules if President Trump gets his way with tax reform.
The IRS regulations are interesting, not only because of the 2010 anomaly in the estate tax rules, but also because President Trump has proposed repealing the estate tax and instead requiring the use of a carryover basis for estate assets, just like in 2010. However, Trump’s plan would allow a $5 million exemption per person of the appreciation on estate assets. Thus, the IRS’s final rules for 2010 give insight into how an estate carryover basis could work going forward.
Stepped-Up v. Carry-Over Basis
Gain or loss on the disposition of property is measured by the taxpayer’s amount realized (i.e., gross proceeds received), less the taxpayer’s basis in the property. Basis generally represents a taxpayer’s investment in property. Basis is increased by the cost of capital improvements made to the property and decreased by depreciation deductions taken.
Basis in property received by gift
Property received from a donor as a gift takes a carryover basis. “Carryover basis” means that the basis in the hands of the donee is the same as it was in the hands of the donor. As a result, any appreciation in the property will be taxed to the donee when the property is eventually sold.
For example, if an uncle has property he purchased for $100,000 and gives it to his niece when it is worth $200,000, the niece takes the uncle’s $100,000 basis in the property. When the niece sells the property later for $250,000, she will realize a $150,000 capital gain (the $250,000 sales price minus the $100,000 carryover basis).
Basis in property received from a decedent
Property passing from a decedent takes a “stepped-up basis,” the fair market value on the date of the decedent’s death or an alternate valuation date if chosen by the executor. This step-up in basis eliminates the recognition of gain on any appreciation of the property that occurred prior to the decedent’s death. Under the stepped-up basis rules, if the uncle had a basis of $100,000 in an asset and the fair market value at death was $200,000, then the niece would get the $200,000 FMV basis and only would have $50,000 gain from a sale for $250,000.
However, this provision works both ways. If the value of property on the date of the decedent’s death is less than its adjusted basis, the property takes a stepped-down basis when it passes from a decedent’s estate. For example, if the uncle purchased property for $200,000 and it is worth $100,000 when he dies, the niece who takes the property has a $100,000 basis in the property, which reduces any loss deduction upon sale.