On Dec. 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. Among other provisions, the Tax Relief Act modified and extended the estate tax provisions of 2010 through Dec. 31, 2012 only, resulting in a retroactive reinstatement of the U.S. estate tax for deaths that occurred in 2010.
For beneficiaries of decedents in 2010, U.S. Congress provided two systems of taxing estates and determining basis of their assets: the decedent’s beneficiaries will have the choice of either applying the federal estate tax or making use of the “modified carryover basis regime.”
Executors of those estates are left to determine the better course.
To do so, especially for valuations of gross estates valued over the new $5 million exclusion, they must take many factors and considerations into account. The beneficiaries will need to choose between receiving an unlimited “step up” and use the available $5 million exclusion or elect out of the U.S. estate tax, chose a limited step up in the taxation basis of the inherited property and, instead allow assets to pass tax-free to the beneficiaries under the modified carryover basis regime with its own basis for exclusions but without the step-up to fair market value upon the date of death.
For income tax purposes, the income tax basis of an asset is the price paid for the property plus the value of certain improvements. In the case of stocks and bonds, the basis equals the purchase price whereas for real estate the basis equals the purchase price plus the value of all capital improvements (special assessments levied during the years of ownership) as well as real estate closing costs.
For the tax years prior to and following 2010, beneficiaries of an estate are entitled to receive a “step up” in the basis of the property they inherit meaning regardless of what the decedent paid for the property, the beneficiaries will inherit the property at the fair market value as of the date of death. So if the decedent paid $500,000 for the real estate and did not make any capital improvements and at the date of death the fair market value of the real estate had increased to $750,000, then the beneficiaries would inherit the property with a stepped up income tax basis of $750,000.
“Modified Carryover Basis Regime”
Only for deaths that occurred in 2010 would the decedent’s beneficiaries have the choice to either take a full step up in basis or use the modified carryover basis regime. If the beneficiaries opt to apply the modified carryover basis rules, then it means that the property will pass at the lesser of:
A) the fair market value on the date of death; or
B) the decedent’s original income tax basis in the property plus the value of certain improvements, but not at the full stepped up basis.
For example, if a decedent paid $300,000 for real estate and did not make any capital improvements to it, and the fair market value at the date of death in 2010 increased to $500,000, then the beneficiaries would inherit the property with a carryover income tax basis of $300,000. However, if the fair market of the value of the property decreased to $200,000 upon the decedent’s date of death, then the beneficiaries’ basis in the property would only be $200,000.
That said, the carryover basis is subject to adjustment under the modified carryover basis rules. Where the decedent is neither a resident nor a citizen of the U.S. (Canadian decedent owning US real estate), the modified basis carryover rules limit the amount of the basis increase to $60,000 (as opposed to $1,300,000 for a US resident/citizen).
Examples of Applying the Modified Carryover Basis Regime to a Deceased Person’s Property
Using the example above, a non-spouse beneficiary can only increase the carryover basis by up to $60,000 so that the non-spouse’s beneficiary’s modified carryover basis will be $360,000 instead of $500,000.
Thus, if the beneficiary sells the property with a modified carryover basis of $360,000 shortly after the decedent’s death for the fair market value of $500,000, then the beneficiary will owe capital gains tax on the net gain of $140,000, which is the difference between the sales price and the non-spouse beneficiary’s modified carryover basis:
$500,000 – $360,000 fair market value modified carryover basis = $140,000 net gain
Contrast this with the sale of the property by applying a full step up in basis, in which case the basis of the property will be stepped up to the date of death value of $500,000 so that the sale will not generate any capital gains taxes:
$500,000 fair market value – $500,000 stepped up basis = $0 net gain
Using the same example, if the property has an original income tax basis of $300,000 but the date of death fair market value has decreased to $200,000, then the basis inherited by the beneficiaries will be $200,000 because the basis cannot be increased beyond the fair market value at date of death.
In light of the above, estate planners who have clients who died in 2010 will have to work with the deceased client’s estate representative to determine whether to make an election provided under the Tax Relief Act.
If the client’s estate is worth less than $5 million, the estate representative generally will not make the election when filing form 706NA “United States Estate (and Generation- Skipping Transfer) Tax Return: Estate of nonresident not a citizen of the United States”. Doing so will allow the assets of the estate to receive a step-up in basis; and the estate representative will not have to deal with the obscure modified carryover basis rules.
If the client’s estate is worth more than $5 million, the client’s estate representative may opt for the Modified Carryover Basis regime by preparing and filing no later than January 17, 2012 form 8939: “Allocation of Increase in Basis for Property Acquired From a Decedent: To be filed for decedents dying after December 31, 2009, and before January 1, 2011”.
Factors that may provide the estate planner with hints of the best strategy to deploy include:
- Fair Market Value of the property (i.e. gain or loss vs. Tax basis);
- Anticipated future sale of the property;
- Estate tax vs. Capital Gain tax;
- Canadian deemed disposition at date of death; and
- The relative size of the estate.
Canadian executors should always seek advice from qualified Cross Border tax and estate Specialists.