New Estate Law Imposes Burden On All - The Hassle of Carry Over Basis

Most people are aware that Congress failed to act with regard to the federal estate tax situation, the result being that currently for year 2010, there is no federal estate tax and in year 2011, the federal estate tax comes back with a vengeance with an only $1 million exemption. Although several senators have promised to do something about the lack of tax revenue coming in for 2010 by way of passing legislation that will have a retroactive effect to all deaths which occur from January 1, 2010, based on their past performance, one would be foolish to accept those promises as an accurate prediction of what is going to happen.

Although seemingly simple, the situation has created a very complicated maelstrom for those estates which were created by those who will be unfortunate enough to die in the year 2010.

Limited Step Up In Basis. For some reason, one of the issues that gets limited attention with regard to all of this is the new limitation in available stepped up basis. Back in 2001 when the law which created this debacle was drafted, the legislators sought to find some way to reimburse the government for its projected loss of revenue for the years in which there would be no federal estate tax. The way that they did this was to greatly limit the step up in the tax basis that beneficiaries would have in the assets that they inherited.

Previous Law. Prior to January 1, 2010, when a beneficiary inherited assets, the tax basis of the assets were stepped up to date of death value for federal income tax purposes. For those of you who are not familiar with the concepts of basis, it can be explained as follows:

“Basis” is the IRS word for “cost”. Technically, it is cost and provable improvements, but for purposes of this article, we’ll just use cost. When an asset is sold, its gain or loss for income tax purposes is measured by subtracting the asset’s basis from the sales price. If there is a gain, it is taxed by both the federal and state governments.

As mentioned above, previously when a beneficiary inherited assets, the government permitted the beneficiary to use the date of death value as the new cost basis on all of the assets. Until recently, this was usually a very substantial income tax benefit because until the last year, most assets were appreciating and the difference between the original cost basis’ and the date of death values was impressive. All of that has now changed.

New law. As of January 1, 2010, the executor of the estate may now allocate only $1.3 million worth of the decedent’s original cost basis assets to increase in basis to their date of death fair market values. For example, assume a decedent owns a parcel of real estate worth $5 million at his death, for which his cost basis is only $800,000. Under the new law, the cost basis will remain at the $800,000, unless the executor elects to allocate all or a portion of the $1.3 million basis increase to that asset.

Note that for married couples, the surviving spouse is entitled to an additional $3 million in basis increase provided that the spouse inherits the property outright or through a QTIP (Qualified Terminal Interest Property) Trust. (The problems that married couple trusts are put to under the new law will be the subject of my next article.)

For the remaining assets in a decedent’s estate, the executor must report their basis at the LESSER of their original fair market value or their date of death value.

Executor’s Duty to Report to IRS. What is obviously essential to this picture is that the executor must know exactly what the cost basis is for all of a decedent’s assets in order to know how best to allocate the $1.3 million basis increase. This will prove to be an enormous problem for many executors since many people don’t have the faintest idea what they originally paid for their individual securities or some of their real estate. If they don’t know, how can their executor be expected to know? But the IRS does expect them to know, and they will have only 9 months from the date of death to find out. The result is going to be a major headache for the executors and their financial team (CPA and financial advisor), as they will be forced to research the valuations at the date of purchase and prove those valuations to the satisfaction of the IRS. Failure to file the financial information with the IRS can result in a $10,000 fine against the estate. In addition, the IRS will require the names of all parties who inherited the assets.

What You Need to Do. The burden is on everyone to make sure that they leave appropriate records with their wills and trusts which can be used by the executor to prove the original tax basis of all of the estate and trust assets. So start photocopying those real estate purchase agreements, original securities orders, acknowledgments of contributions to limited partnerships, etc.

Although the senators are promising to change the federal estate tax exemption, curiously, nobody is talking about the carry over basis, so we are far from a guarantee that this situation is going to change, even if the exemption changes.