Modified Carryover Basis Regime – U.S. Estate Tax for Deaths that Occurred in 2010

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.

Dollars and Sense Radio Show – November 24, 2011

Montreal, Quebec – November 24, 2011

On the November 24th episode of Dollars and Sense on CJAD 800 AM, host, Matt Altro and legal expert David A. Altro discuss Owning U.S. Property – The Canadian Way, 2nd Edition and all the important issues surrounding Canadians buying property in the U.S. and moving to the U.S.

David answers your questions and explains U.S. tax laws and their implications and how to protect yourself and your family from the U.S. probate procedure, creditors, taxes and much more.

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

David A. Altro interviewed by the Toronto Sun

U.S. property investment pitfalls easy to overcome

The Toronto Sun
November 10, 2011

A growing number of Canadians are tempted by property bargains in the U.S., but are being put off by bad information about the possible tax pitfalls, according to David Altro, a lawyer and author of a book on the subject.

The baby boomer generation is looking for a warm place to retire and being lured by property at bargain-basement levels, making Canadians the biggest foreign investors in U.S. real estate.

“I wrote this book because there is a lot of mis-information out there for Canadians wanting to buy or move to the U.S.,” Altro said, whose Owning U.S. Property The Canadian Way is now into its second edition.

Much of it revolves around the potential tax bill and bureaucratic headaches for family members trying to sort out the estate upon the death of the property owner.

Altro said a lot of these problems can be avoided completely by setting up an irrevocable cross-border trust. That will help provide protection from creditors for your children and get around expensive U.S. laws on probate.

Similarly, placing your property in a trust is also beneficial if either you or your spouse becomes incapacitated. Under U.S. law, if one person becomes incapacitated the property can effectively be frozen and will require a series of costly headaches to un-freeze.

“A trust can’t become incapacitated,” Altro said.

Many property advisers recommend setting up a corporation to hold and manage U.S. property assets, though Altro said that is not tax effective.

Capital gains on a cross-border trust are taxed at about 15%, compared with a rate of more than 40% for corporations in Florida.

Although there are fees involved with setting up such a trust, Altro says “they are very small” compared with the costs of a potential tax bill or legal help to sort out problems once they have occurred.

There may be another upside for Canadians wanting to buy U.S. property. If they choose to become U.S. residents their income tax bills will drop substantially. Altro said the maximum U.S. income tax is 35% and that kicks in on earnings of more than $375,000. In Canada, the high rate is 46% on income of more than $125,000.

But for many that requires obtaining an elusive Green Card. A bill put forward by two U.S. senators eager to promote further investment in the country’s sagging real estate market may put a visa within reach.

The bipartisan proposal put forward last month would grant a visa to foreigners spending at least $500,000 on residential property.

Residential sales of U.S. properties to foreigners and recent immigrants totalled $82 billion in the 12-month period ended March 31, up from $66 billion the previous year, according to the National Association of Realtors. California accounted for 12% of those sales, second only to Florida.

David A. Altro featured on Droit Inc.

Investissements immobiliers aux USA: la bonne méthode, selon un avocat
Par Agence QMI
Le 14 novembre 2011

C’est le point de vue de David Altro, avocat et auteur d’un livre sur le sujet. L’ouvrage, intitulé Owning U.S. Property – The Canadian Way, en est à sa deuxième édition.

« J’ai écrit ce livre parce que les Canadiens qui veulent acheter aux États-Unis ou s’y installer sont confrontés à trop d’informations erronées », a-t-il dit.

Selon M. Altro, c’est surtout au sujet des comptes de taxes et des démarches à effectuer dans le cas d’une succession que les informations pertinentes manquent.

Pourtant, les embûches peuvent être facilement évitées, explique David Altro, en créant une fiducie transfrontalière irrévocable. Cette structure permet en effet de protéger les héritiers d’éventuels créanciers et de contourner la réglementation américaine sur les successions, souvent coûteuse.

Mettre une propriété en fiducie présente aussi des avantages si l’un des deux conjoints se retrouve privé de capacité légale. D’après la loi américaine, dans un tel cas, toutes les opérations concernant la propriété sont bloquées et lever ce blocage peut s’avérer particulièrement long et difficile.

« Une fiducie ne peut pas être privée de capacité légale », a expliqué David Altro.

De nombreux conseillers financiers recommandent, pour leur part, de créer une société par actions pour gérer les propriétés aux États-Unis, mais, selon M. Altro, ce n’est pas une solution idéale sur le plan fiscal.

Les profits sur cession réalisés dans le cadre de fiducies transfrontalières sont taxés à hauteur de 15 %, alors que dans le cas d’une société par actions, ce taux peut monter à 40 %, comme en Floride.

Créer une fiducie a bien sûr un coût, a reconnu David Altro, mais ce coût est bien inférieur à ce qu’il faudrait payer en compte de taxes ou pour obtenir de l’aide juridique dans le cas d’une succession, d’une incapacité légale ou de tout autre problème.

Faire des États-Unis son lieu de résidence présente par ailleurs de sérieux avantages fiscaux pour ceux qui veulent accéder à la propriété au sud de la frontière.

Aux États-Unis, le taux d’imposition maximum est de 35%, et il s’applique aux ménages disposant de revenus supérieurs à 375 000 $. Au Canada, le taux maximum est de 46 % et il s’applique à partir de 125 000 $ de revenus.

Devenir résident permanent aux États-Unis nécessite une carte verte, mais ce document n’est pas facile à obtenir. Deux sénateurs américains ont toutefois proposé une loi pour faciliter l’obtention de visas pour ceux qui veulent acheter aux États-Unis. Ils estiment que cela permettrait de stimuler le marché immobilier, actuellement en plein marasme.

Selon cette proposition, déposée le mois dernier à Washington, tout étranger investissant au moins 500 000 $ dans l’immobilier résidentiel pourrait obtenir un visa de résident permanent.

Les ventes de propriétés résidentielles américaines à des étrangers ou des immigrants récemment arrivés aux États-Unis ont atteint 80 milliards $ pour la période de 12 mois achevée en mars 2011, comparativement à 66 milliards $ pour la même période de l’année précédente, selon l’Association nationale des agents immobiliers américains.

To read this article in English, please click here.