The Mystery of Carry-over Basis and Its Effect On Estate Administration

Authored by: Michael C. Levy, Esq.

With less than a third of 2010 remaining, we once again find ourselves on the verge of a major change to the federal estate tax system.  If Congress fails to pass estate tax legislation by the end of the year, the estate tax will return on January 1st with a $1 million exemption per decedent and a maximum tax rate of 55%.  That’s the bad news.  The good news is that in addition to the estate tax returning, the rules regarding “step up” basis will return, replacing the current carry-over basis rules which are in effect for 2010.

The end result of this change could prove significant to those with estate assets that have appreciated significantly since their purchase.  Under the ‘step-up’ rules, inherited property assumes a tax basis equivalent to the fair market value of that property at the time of the decedent’s death.  Alternatively, an executor may choose to value the assets six months from the date of the decedent’s death if the value of the property and the tax due would be lower than the date of death value.  Thus, the beneficiaries of this property receive all the appreciation of the decedent’s property without any imputed capital gain.

The current carry-over basis rules treat inherited property in a less taxpayer friendly manner.  Inherited property may still receive a step-up in basis up to a cumulative $1.3 million for all property from an estate and property inherited by a spouse may receive an additional $3 million step up.  Beyond these two ‘exemptions,’ the beneficiaries of inherited property may receive a much lower basis in the property and end up subject to capital gains tax when the property is sold.

This creates significant issues for administering estates for decedent’s dying in 2010.  An administrator or executor must determine which property to apply the step-up basis to and whether they should apply it to one category of property or spread it across all inherited property.  Muddying the water even further, the IRS has yet to release any worksheets or forms to guide executors on how to allocate these exemptions.  This uncertainty makes the job of a fiduciary even more difficult and may leave fiduciaries open for complaints from the beneficiaries they serve and potentially claims of breach of duty.

It has been an unfortunate misnomer that the estate tax repeal would make things easier for estate administrators and executors.  The little discussed change to the basis rules have, on the contrary, made things even more difficult.  A return to the step-up basis rules will make their job significantly easier even if it comes at the cost of a lower estate tax exemption.

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