Before 2010, any assets that passed to someone on your death
received a new basis for income tax purposes equal to its fair market
value as of the date of death. (This is referred to as a “step-up in
basis.”) Thus after your death, when a surviving spouse or heirs sold
any assets (like securities or a home) that had increased in value
during your lifetime, they would not have to pay income tax on any of
that growth. For many heirs, this meant huge income tax savings,
oftentimes tens of thousands of dollars or more.
BUT NOW ............property that passes at death does not automatically
receive this step-up in basis.
Instead, each individual has a limited
amount of property that can be “stepped-up” in value at the time of
their death. Property that does not receive this step-up value will be
subject to tax on all increase in value from the date you first acquired the property. This means that the property could be exposed to tens of thousands of dollars of income tax liability for your heirs!
Not surprisingly, these rules are convoluted and in many cases very
different from the old law. In fact, Congress attempted to institute a
similar tax structure in the 1980s and it was repealed, retroactively,
because it was too difficult to administer. Because of this past
experience as well as the anticipated difficulties in calculating such
a tax, the common belief was that Congress would change the law before
January 1, 2010. But it didn’t.
How You Are Affected?
This law can affect you in several ways. First, for those of you
who did not have an estate tax issue previously because the value of
your estate fell below the applicable exclusion amount, it is important
to remember the new income tax rules (the loss of the step-up in basis)will apply to everyone
no matter the size of your estate. Your current estate plan may work
under the estate tax rules, but may inadvertently cause an income tax
issue which will be payable upon your death.
Second, for married couples as well as single clients, you need to
first make sure that your property will be distributed according to your
desires, and not dictated by Congress. For more than 50 years, it has
been common to use a written mathematical formula to divide the assets
of a married couple when the first spouse dies to maximize estate tax
savings. Likewise, formulas have been used to provide funds for
charitable causes and to benefit family and friends.
Effective 2010,
when there is no estate tax, these formulas may not work. If a spouse
is not your sole beneficiary (for example, if you have children from a
prior marriage), the existing formula could result in the
disinheritance or substantial reduction of resources provided for the
surviving spouse.
What Should You Do?
Meet with a qualified estate attorney as soon as
possible to review your estate plan and make any changes that may be
necessary under the current law. Ensure your property
is positioned to receive the maximum step-up in basis increase
available under the current law as well as provide for the possibility
that Congress may enact legislature in the near future that would
retain an estate tax structure.
This is a time that demands a new
approach to your planning with new thinking and the building in of
flexibility to your estate plan to see that your wishes are fulfilled
no matter what Congress will throw at us this year or next.
Q. If the Estate Tax is not resurrected and made
retroactive to January 1, 2010, how will the carry over basis tax be
assessed and reported?
Answer: The allocation of the aggregate basis increase will be made by the executor on each asset, and reported on a "Basis return." All
assets of the decedent (whether or not they are part of an estate
processed through Probate Court) will be part of the calculation. The
report is required if all property acquired from the decedent exceeds
the $1.3 million aggregate adjustment. §6018. The
$1.3 million basis adjustment will be increased by any unused capital
losses, net operating losses and other "built-in" losses of the
decedent. But the Wall Street Journal predicts this "wiggle room" will
require " multigenerational record-keeping nightmares on assets ranging
from real estate to stocks to family heirlooms. Heirs would have to
scramble to find out what things cost decades before when preparing tax
returns."
Q. What assets would be eligible for the basis adjustments?
Answer:Property owned by the decedent at time of his or her death. §1022(d)(1)(A)
Q. How wIll Jointly held property be taxed?
Answer: The decedent shall be treated as the owner to the extent of the
value of a fractional part to be determined by dividing: the value of the property by the number of joint tenants who have right of survivorship.§1022(d)(1)(B) (i)(III)
Q. What About Revocable Trusts?
Answer: The
decedent shall be treated as owning property transferred by the
decedent during life to a qualified revocable trust (as defined in
section 645 (b)(1)). See §1022(d)(1)(B)(ii)
Q. Will Recently Gifted Assets be Part of the Estate?
Answer: No.
The basis increase does not apply to property acquired by the decedent
by gift or by inter vivos transfer for less than adequate and full
consideration in money or money’s worth during the 3-year period ending on the date of the decedent’s death. §1022(d)(1)(C)(i).
But there is an Important Exception for Married Couples! Subsection
(i) does not apply, unless, during the 3-year period, the spouse who
transfers the asset to his/her spouse had acquired the property in
whole or in part by gift or by inter vivos transfer for less than
adequate and full consideration in money or money’s worth.
§1022(d)(1)(C)(ii)
Q. What About IRA's and other Income in Respect of a Decedent?
Answer: Basis
increase does not apply to property which constitutes a right to
receive an item of income in respect of a decedent under section 691.
Retirement plans and other IRD will not be eligible for the allocation
of step-up basis. IRA's will be taxed as "ordinary income," not capital
gains. §1022(f).
Q. Will Life Insurance Proceeds Need an Adjustment in Basis?
Answer: Life
insurance will retain its long standing tax-privileged status under the
new adjusted basis regime. The income tax exclusion for life insurance
proceeds is untouched. No need to allocate any of the decedent's
carryover basis adjustments to life insurance.
Q. Can people get around the "carry over" basis rules by loading up on debt?
Answer: There will be recognition of gain if a loss exceeds the adjusted basis. §1001.
Q. Is the spousal adjustment of $3 million in addition to the aggregate basis adjustment of $1.3 million?
Answer: Yes.
In addition to the aggregate basis increase, the spouse gets another $3
million adjustment. With planning, a couple can pass assets worth up to
$4.3 million with no capital gains tax when the assets are sold by
heirs. The adjustment is allowed only for property passing to a
surviving spouse outright or in a qualified terminable interest
property or QTIP TRUST.
The
spousal exception to the 3 year rule against gifts could be used by one
spouse to transfer an asset with a low basis to an ill spouse, who
could then leave the asset by bequest, devise or inheritance to the
surviving spouse with an increased basis!
The spouse could then
sell the asset for FMV without recognizing any federal capital gains
tax. This concept may become known as "basis laundering" for married
couples.
Q. What about Life Estates, where Parents Have Transferred Remainder Ownership of the Homes to their Children?
Answer:
Beginning in 2010, a capital gains problem will be passed down to the
children upon the death of the parents who used a life estate
arrangement to transfer ownership of their home. The tax laws that took
effect on January 1, 2010 do not allow an exemption from gains on
assets that were transferred during a person's lifetime, subject to a
retained life estate interest. In contrast, a person who sold assets that they inherited before 2010 was allowed to compute his or her
gain or loss based on the value of the assets as of the decedent's date of death.
A new section of the Internal Revenue Code, Section 1022,
replaces former IRC Section 1014, which had allowed a "step up" in the
basis value of a home or any other asset that had been transferred
during the lifetime of a person who retained a life estate. This has a
big impact on middle class clients who transferred their homes to their
children and retained life estates, or placed their home into an
irrevocable trust that names the children as remainder beneficiaries.
The National Academy of Elder Law Attorneys has asked the Internal
Revenue Service to clarify whether remainder owners will be entitled to
have the basis increased under the new Section 1022. Click to Read Letter.
As of April 26, 2010, the IRS has not responded to the NAELA request
letter. NAELA is suggesting that the IRS clarify the situation, and
issue a notice stating that these life estate and irrevocable trust
ownership arrangements be entitled to have the basis increased under
Section 1022:
- the remainder people of a deed where the decedent retained a life estate,
- the remainder people of an irrevocable trust where the decedent retained the income interest for life
It
is uncertain whether the IRS can issue a notice that would allow a step
up in basis for life estate remainder people and irrevocable trust
beneficiaries, since the tax treatment of Life Estates and trusts was
changed by an act of Congress.
The new tax laws do
make provisions for property that has been transferred to a trust, if
the decedent keeps the right to change any beneficial ownership of the
trust property. Section 1022(e)(2)(B) states that property shall be considered to have been acquired from the decedent: if it was transferred by the decedent:
(B)
to any other trust with respect to which the decedent reserved the
right to make any change in the enjoyment thereof through the exercise
of a power to alter, amend, or terminate the trust.
But the IRS has not issued Revenue Regulations to explain the scope of
this subsection. Could the IRS interpret a Life Estate as being a
reserved interest sufficient to alter the enjoyment of the property
under Section 1022(e)(2)(B) ??? That seems too great a stretch. After
all, Congress clearly terminated the step up in basis treatment for
Life Estates that had been contained in Section 1014. Under Section
1014(f) , the step up in basis, "shall not apply with respect to
decedents dying after December 31, 2009." Old Revenue Regulations under
this statute had allowed a step up in basis on remainder interests. See
the old regulations at 26 CFR § 1.1014-5.
Yet,
some elder law and tax attorneys believe that an argument can be made
that Section 1022(d) DOES include life estates, since the lifetime
owner has exclusive possession of the entire property, and the
remainderpersons do not have a possessory interest in the premises
until the lifetime owners die.
Will
Congress vote to reinstate the basis step - up for the value of a life
estate remainder? Will the IRS issue an administrative ruling on this
problem? We will let you know about this issue. If you have questions,
please call for an appointment: (413) 567-5600.
Some
elders who want to sell their homes, after having transferring
ownership to their children, may be trapped in their capital gains.
