For formatted, searchable PDF file, press here:  New Carryover Basis Rules.wpd

Enacted as part of the 2001 Tax Act, IRC § 1022 repeals the current basis step-up at death for property owned by a decedent, and replaces it with a carryover basis provision effective on January 1, 2010. If estate tax repeal occurs as scheduled on December 31, 2009, the new basis rules must be planned for, as they will effect a sea change in income and estate taxation. Congress is unlikely to repeal the estate tax without a return to carryover basis.

Some property will still be allowed a basis increase under new IRC § 1022: the executor will be entitled to allocate basis increases of up to $1.3 million to specific assets, up to the FMV of the asset. However, no basis adjustment may be made with respect to to IRD property. IRC § 1022(f). Property transferred to a surviving spouse will be entitled to a basis increase of up to $3 million, provided the assets pass in a form that would have qualified for the marital deduction. Another negative twist: basis will not be carried over if the basis at death is less than FMV; in that case, basis will be stepped-down to FMV.

IRC § 1014 currently allows a basis increase for all property acquired or passing from a decedent. While IRC § 1022 also speaks of “property acquired from a decedent,” the definition is expanded to include, inter alia, any property “passing from the decedent by reason of death to the extent that such property passed without consideration.” The significance of this definition is its breadth: Conceivably, property not now included in a decedent’s gross estate could be subject to the new carryover basis rules. For example, a QPRT which terminates on the decedent’s death and distributes a residence to the the decedent’s children could be snared by the new rule requiring the children, upon selling the house, to report capital gain based on the lesser of the basis at the time of the decedent’s death and the time the decedent transferred the residence into the trust.

As noted, the application of IRC § 1022 to property not presently included in the decedent’s gross estate constitutes one planning problem. Another problem is that not all property subject to IRC § 1022 will be entitled to the partial free pass afforded by the $1.3 million general basis step-up and the $3.0 million basis step-up for property passing to a spouse. For example, paragraph (d)(1)(B)(iii) provides that the decedent “shall not be treated as owning any property by reason of holding a power of appointment with respect to such property.” Therefore, QTIP property taxed in the estate of a surviving spouse would not be considered “owned” by the surviving spouse, and its assets would not be entitled to a basis increase. (A similar fate would apparently befall other interests, such as GRATs or QPRTs in which the decedent does not survive the trust term. That property, although “acquired” from the decedent, might not be treated as having been “owned” by the decedent, and would therefore be ineligible for the basis increase allocation.)  HOWEVER, SINCE THERE IS NO ESTATE TAX IN 2010, NO QTIP ELECTION NEEDS TO BE MADE.  THEREFORE, THE PROPERTY IN THE TRUST, FOR WHICH  NO QTIP ELECTION IS MADE, WOULD NOT BE INCLUDED IN THE ESTATE OF THE SURVIVING SPOUSE.

In general, no basis increase will be allowed with respect to property acquired by the decedent by gift within three years of death. § 1022(d)(1)(C)(i). Therefore, a relative could not gift low basis property to a person with a short life expectancy in the hope that the property would be bequeathed back with a basis increase. Interestingly, this limitation does not apply to property acquired by gift from a spouse. IRC § 1022(d)(1)(C)(ii). While current law curtails deathbed transfers to a spouse for less than full consideration, a transfer of property from a healthy spouse to a terminally ill spouse would qualify for both the $1.3 and $3 million basis increase allocations.

The transfer of property by an estate in satisfaction of a pecuniary bequest is a “sale or exchange” and thus triggers gain (or loss) recognition. After 2009, however, gain or loss on the transfer of property in satisfaction of a pecuniary bequest will be recognized only to the extent that the FMV of the property at the time of transfer exceeds the FMV at the decedent’s death, rather than its carryover basis.  IRC § 1040(a).

An acute planning problem could have been encountered with respect to the IRC § 121 exclusion of $250,000 for the sale of a principal residence, since the estate (or beneficiary) could have been required to pay capital gains tax upon the sale of the residence. Fortunately, effective after 2009, IRC § 121(d)(9) permits the $250,000 exclusion to be utilized by an estate or heir provided the decedent utilized the property as a principal residence for two or more years during the five-year period before the sale.

One would be inclined to think that the elimination of the estate tax might cause some to reduce the marital deduction share since property passing to children would attract no estate tax. However, in many situations it might still be necessary to set aside a marital share — if only to fully utilize the $3 million spousal basis increase. To illustrate, assume decedent dies owning shares of Cisco Systems with a basis of $430k but worth $4.3 million at death. If nothing is allocated to the marital share, capital gains tax on at least $3 million shares with an allocable basis of $300k would total $486,000, assuming a capital gains tax rate of 18%. On the other hand, if the spousal share were increased to $3 million, this capital gains tax could be avoided.

The executor may not have the discretion to determine the amount to be allocated to the spousal share, as that might constitute a terminable interest rule. The analogue of a “partial” QTIP election may also be unavailable.  Although a spousal disclaimer might work, the individual might not want to condition averting an income tax fiasco on a mere spousal disclaimer.