Summary: Carryover basis is the law for those decedents who died in 2010. While the media has hyped the lucky heirs of billionaires who died in 2010 without an estate tax, the tax picture doesn’t stop with the No Estate Tax Party those kids are hosting. The CPAs for these lucky heirs have a lot of work ahead of them and the deadline clock is ticking.
√The tax basis of assets inherited from a decedent is the lower of the decedent’s adjusted basis (cost, less depreciation, plus improvements) or the fair market value of the asset on the date of death. To figure this out estates need both: (1) Appraisals of all assets to demonstrate fair value at death; and (2) Corroboration of the decedent’s basis. This all will require a lot of work and some big bills. The toughest challenge may be convincing heirs to spend the dough to do the necessary work, after all there is no tax in 2010! True, but even more complex tax filings and calculations are required. If capital gains rates rise in the future this homework will be really important to minimize future taxes.
√ Don’t wait for forms. Tax filings are due 4/15/11 and the allocation of basis adjustments will have to be reported 5/15/11.
√The tax basis in a 2010 decedent’s assets may qualify to be increased (adjusted) to eliminate unrecognized gain of up to $1.3 million on property passing to anyone, and up to $3 million for property passing outright to a spouse or in a trust that meets the requirements of Qualified Spousal Property.
√If the estate has less appreciation then the available adjustments ($1.3M + $3M + others) then the incentive might be to value assets as high as possible to obtain the maximum basis step up to minimize future capital gains. That might be tempered if there is a state level estate tax. If the appreciation is greater than the available basis adjustments, then the fun really begins. Which assets do you allocate the adjustment to? If the assets are distributed disproportionately to different heirs (e.g., business to one heir, family cottage to another) the fun might become fireworks! Read on for factors to consider.
√What is the expected holding period for the property? If property, such as a family cottage, is intended to remain for generations in the family it is less in need of an allocation to increase basis than are other assets which are more likely to be sold.
√Are other avenues to avoid, defer or minimize the potential future capital gains tax available and how does their availability compare to other assets in the estate if the maximum basis adjustment has to be rationed to the various assets?
√Will a CRT defer the tax so long that basis adjustment should be allocated elsewhere? If the estate holds raw land that is likely to be donated to the local church for an expansion project the basis adjustment is less important as compared to other assets if a charitable remainder trust or outright donation is used.
√Might a 1031 tax free exchange change the analysis? If the estate owns a shopping center and rather than sell it, if a tax deferred Code Section 1031 exchange is a likely possibility, then the allocation of basis to the shopping center may be less advantageous than an allocation to other assets.
√Exchange funds might be part of the plan. If highly appreciated securities could be contributed to an exchange fund to diversify without incurring capital gains then these assets would be less in need of an allocation.
√If the decedent’s principal residence can be sold and exclude gain under the home sale exclusion rules then to the extent that that exclusion will avoid taxable gain, basis adjustment should not favor the residence.
√What will the capital gains tax rates be when the assets are sold in the future? Get out your crystal ball and your abacus and guess which rates apply at which income levels, how the Medicare tax on investment income factors into the calculus, and more!
√What will the tax bracket and status of the beneficiaries receiving the property be?
The myriad of factors and competing interests of different beneficiaries will also make it difficult for advisers to evaluate and weigh the many options. Many states have enacted laws that provide that formula clauses under a will (e.g., give the largest amount that won’t create a federal estate tax to a credit shelter trust) should be interpreted based on 2009 estate tax rules. Executors may have to apply and interpret state statutes enacted to deal with formula clauses to determine who receives which assets even before they evaluate options for allocating the $1.3 million or $3 million basis adjustment.
√The estate’s CPA should prepare a worksheet identifying every asset and listing: ◙ Tax basis ◙ Corroboration or estimates of how tax basis was determined (there will be some fancy footwork to come up with these numbers) ◙ Fair market value of each asset with a reference to the appraisal or other source of the determination of value ◙ Classification of the asset (e.g., certain assets such as IRD won’t qualify for basis step up), whether the asset qualifies for the general basis adjustment of $1.3 million and/or the spousal adjustment of $3 million ◙ Other possible basis adjustments (special rules are provided for NOLs, homes, etc.) ◙ Factors considered in allocating the basis adjustment to each asset ◙ The actual allocated basis adjustment ◙ Final tax basis for each asset. Totals for the worksheet should tie out to the value of the entire estate, the maximum basis adjustments, etc. to prove compliance with the new law. This spreadsheet will be somewhat analogous to worksheets CPAs prepare to allocate 754 basis adjustments.√Even if Congress gives 2010 estates the option of using carryover basis or 2009 rules you’ll still need calculations to confirm the decision.
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