Private Client Services Update – Practical Considerations When Navigating the New Modified Carryover Basis Rules

    By Alexander W. Powell Jr., Lewis W. Webb III, Estate, Trust & Wealth Transfer

    While most of the focus on estate-related tax law this year has centered on the repeal of the federal estate tax, the accompanying change in the stepped-up basis rules affects a substantially larger number of estates. Under the new law, property acquired from a decedent dying in 2010 receives a modified carryover basis rather than a full step-up in basis equal to the fair market value at the decedent’s date of death. While this may conceptually appear simple, the implementation of the new law provides complexities that can be a trap for the unwary.

    Prior Basis Step Up Rules
    To understand the impact of the new law, one must first understand how the prior low operated. The tax basis of property acquired from a decedent dying last year was stepped up to the fair market value of the property on the decedent’s date of death. Thus, if the property had increased in value during the decedent’s lifetime, the unrealized capital gain permanently escaped income taxation. Additionally, the person acquiring the property was deemed to have held the property long term regardless of the actual holding period of the decedent; therefore, any post-death gains were treated as long-term capital gains, even if the property was sold within one year of the decedent’s death.

    Current Modified Carryover Basis Rules
    Concurrent with the repeal of the federal estate tax, the full step-up in basis was replaced by a modified carryover basis. Under the new law, the basis of the person acquiring property from a decedent is the lesser of: (a) the adjusted basis of the decedent, or (b) the fair market value of the property at the date of the decedent’s death. There are, however, two adjustments that can be made to this basis which can provide for a combined basis increase of $4.3 million.

    First, an upward basis adjustment in an amount equal to $1.3 million is available for property acquired from a decedent. This amount may also be increased by any capital loss carryover and any net operating loss carryover.

    Second, there is an additional spousal basis adjustment equal to $3 million for property received outright by a surviving spouse or property that would be treated as qualified terminable interest property (QTIP) under the marital deduction rules that applied before 2010. This adjustment is not available for other transfers to spouses, including a life estate.

    Under the new law, the holding period for the person who acquires property is that of the decedent. Thus, short term capital gains can be realized upon sale if the combined holding period of the decedent and person acquiring the property is less than one year.

    Practical Considerations and Potential Traps
    When navigating the modified carryover basis rules, below are some specific issues that an executor should keep in mind:

    Reporting Requirements. The executor of an estate whose assets (excluding cash) exceed $1.3 million in value must file an informational return with the IRS. A return is also required to be filed with respect to property acquired by the decedent, other than from a spouse, within three years of the decedent’s death if such transfer was required to be reported on a gift tax return (regardless of value). The informational return must be filed by the due date of the decedent’s final individual tax return (including extensions). If the executor is unable to make a complete return, the executor must include the name of every person holding an interest in the property, and upon notice from the IRS, such person must file a return. No guidance, however, has been given on how basis is allocated to estates with assets less than $1.3 million where no gift tax return was required to be filed.

    The return must include: (a) the name and tax identification number of the recipient of the property; (b) an accurate description of such property; (c) the adjusted basis of such property in the hands of the decedent and its fair market value at the time of death; (d) the decedent’s holding period for such property; (e) sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income; (f) the amount of any basis increase allocated to the property. The executor must also furnish such information in writing to each person listed in the return as acquiring property from the decedent. Unfortunately, to date, the IRS has not yet issued any forms upon which to make the required reporting.

    The penalties for failure to comply with the filing requirements can be significant: $10,000 for failure to file a required informational return or $50 for each failure to timely provide a beneficiary with the written informational statement. If the failure is due to intentional disregard, the penalty jumps to 5% of the fair market value of the property for which information is required to be reported to the IRS or provided and furnished to persons acquiring such property.

    Property received within three years of death. Property received by a decedent within three years of the decedent’s death will not qualify for an increase in basis unless it was received from the decedent’s spouse. Thus, there is an opportunity to reduce potential capital gains tax liability by making death-bed transfers of low basis assets to a terminally ill individual, provided the transfer is made from the decedent’s spouse.

    Principal Residence. Other potential exclusions available for principal residences should be considered before allocating the basis to the decedent’s principal residence. Under existing law, up to $250,000 of capital gain from the sale of a residence ($500,000 for couples), may be excluded under Section 121 of the Code if the property was used as the taxpayer’s principal residence during at least two of the five years prior to the sale. This exclusion is available to a decedent’s estate or individuals receiving a residence from a decedent’s estate. Spouses of decedents may also use the entire $500,000 exclusion available to couples if the residence is sold within two years of the decedent’s death. If the exclusion under Section 121 is available, the executor may decide against allocating basis increase to a principal residence because it could result in a wasted allocation.

    Fiduciary Obligations. Executors must be mindful of their fiduciary duties when allocating the basis under the new law. Although the law imposes the duty of allocation upon executors, little guidance is likely available from the decedent’s last will and testament as many wills were drafted without specifically addressing this issue. The potential pitfalls for executors are many. First, for assets that have been owned for decades, determining the decedent’s adjusted basis in property could be a daunting task unless the decedent kept meticulous records. Second, executors may face a challenge in balancing (i) the need to sell assets to raise cash to cover estate expenses and the debts of the decedent, (ii) the need to reallocate assets to ensure the assets are invested prudently and (iii) the need to fund trusts, all of which can trigger capital gains tax. Third, executors must ensure that all beneficiaries are treated fairly when deciding which assets to allocate basis or may subject themselves to a potential claim. This can be particularly thorny when the executor is also one of several beneficiaries.

    Because of the nuances and potential pitfalls associated with the newly modified carryover basis rules, executors of estates with decedents dying in 2010 should work closely with their attorneys and other advisors to ensure full compliance with the new law and to maximize any potential tax savings that can be achieved by the permissible basis adjustments.

    Alexander W. Powell Jr. is a partner at Kaufman & Canoles in the firm’s Williamsburg office. His practice focuses on estate planning and administration, tax, and real estate development and land use. Alex can be reached at (757) 259.3877 or

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.