In December 17 of last year President Obama signed into existence the “Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010” to clarify the uncertainties surrounding the future of the federal estate tax – at least for the next two years. As outlined elsewhere in this newsletter, the Act brought back the estate tax at a comparatively generous rate and with a historically large applicable credit for individuals dying on or after January 1, 2010. The Act also has a provision allowing estates of decedents who died in 2010 to “opt out” of the tax. Obviously, given the alternative, the Act was great news to many high net worth individuals.
However, the December legislation also modified important aspects of the federal income tax that has an application to a far larger number of estates. First, the Act continues the 15% long term capital gain rates for all non-corporate taxpayers (including, of course, estates and trusts). Second, with respect to estates and many other forms of property passing from decedents, the Act reinstated the concept of “stepped-up basis” at death in determining taxable capital gains.
Generally, taxable gain on the disposition of property is equal to the sale proceeds minus the “basis” in the property. To overly simplify things, the starting point for determining “basis” in most cases is the cost of the property when purchased by the taxpayer (that starting number is often subject to certain adjustments that don’t concern us here). However, prior to January 1, 2010, the Internal Revenue Code provided for a “step-up” in basis upon the death of the taxpayer. This meant that the value of the property on the date of the taxpayer’s death was substituted for the cost basis of the property. The results were usually favorable for a taxpayer because property values (e.g, real estate prices and the stock prices) generally headed upward. One client once described this concept to me as “free money”.
The other favorable feature of the stepped-up basis rules was that gain on the sale of an asset that had received stepped-up basis automatically received long term capital gain treatment. The Estate did not have to hold the asset for a year, nor did it have to look at the decedent’s holding period in order to evaluate whether the estate was entitled to the lower, long term capital gain rate. This was a pretty terrific feature for illiquid estates that had to sell assets quickly to pay bills or to fund bequests.
On January 1, 2010, stepped-up basis treatment disappeared from the Internal Revenue Code. In its place stood a “carry-over basis” concept that provided that the decedent’s basis in the property was to be used as the basis for the estate’s property. The carry-over basis regime did allow a credit of $1.3 million dollars that could be used to raise the basis up to the date of death value, plus $3 million in credit if the recipient of the property was a surviving spouse. While the credits were generous, the carryover-basis regime presented certain issues: (1) for a large estate (and especially for one where there was no surviving spouse) there remained the possibility that the aggregate basis of all the estate assets, even after application of the credit, would not equal what would have been the “stepped-up basis”; (2) additional record keeping and reporting (as required by the statute) and an additional form would have further complicated many federal returns; and (3) automatic long term treatment for estate property would no longer have been available.
With the return of stepped-up basis at death, much of the uncertainty and added complexity of selling inherited property has been eliminated. Additionally, for large estates and their beneficiaries a future income tax bill may have been reduced; however, there is a potential cost to this last point. If you are the executor or administrator of an estate for a decedent who passed away in 2010 and you file the requisite paperwork to opt out of the Estate Tax, the assets passing from the decedent will not get stepped-up basis. In other words, very large estates cannot have it both ways, they cannot escape the Estate Tax by opting out of it and, at the same time, provide stepped-up basis for the estate’s assets.
– Rod Fluck