Most discussion about the 2010 tax laws has focused on the repeal of the estate tax for 2010 and guesses about what Congress might do in 2011. But although 2010 modified carry-over basis regime has received less coverage, fiduciaries should be aware of how it could affect the sale of assets of individuals who died in 2010.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) replaced the historic full basis step-up system with a modified carryover regime. Under prior law, all appreciation in property that was left to someone at death disappeared. The recipient took a basis that was equal to the value of the asset at the date of death. Under the new Section 1022, the recipient of property inherited from a decedent will generally take a basis that is equal to the decedent’s basis in the property. All built-in appreciation will follow the assets into the hands of the recipients.
The new Section 1022 does provide relief from the general carryover basis rule. The estate is allowed a general $1.3 million basis adjustment for property passing to anyone and an additional $3 million basis adjustment for property passing to a surviving spouse. These adjustments function like coupons that the personal representative can apply toward the appreciation in selected assets. With these coupons, anyone can shelter up to $1.3 million of appreciation from taxation and spouse’s can shelter an additional $3 million.
But what if the taxpayer has more appreciation than is covered by the coupons? Suppose, for example, that Sally inherits land worth $3 million from her grandfather in 2010, and that her grandfather inherited the land from his mother in the early 1940s. However her grandfather’s basis is determined (and this is a real challenge in 2010), the property will likely have more than $1.3 million of appreciation. If Sally sells the property immediately, in 2010, it is likely that most of the proceeds from the sale would be taxable.
This result may be avoidable. EGTRRA provides that, after 2011, the estate tax laws will apply as if EGTRRA had never been enacted. What would be the result of a sale of inherited property EGTRRA had never been enacted? The property would get a full basis step up. This gives Sally an argument—although it may be a stretch—that the appreciation in the property is not taxable if she waits until 2011 to sell it. If this argument is successful, deferring sale of the property until 2011 could result in a substantial tax savings.
This puts fiduciaries, including trustees, in a precarious situation. Fiduciaries usually sell assets to meet cash needs as soon as the needs are determined, thereby minimizing investment risk due to market volatility. But now the fiduciary has a dilemma: If the fiduciary waits until 2011 to sell the asset, the appreciation in the property may escape taxation, but this will expose the fiduciary to investment risk due to market volatility between now and 2011.
So what should the prudent fiduciary do? Sell now and take the risk of losing the possibility of full basis step-up, or sell later and take investment risk due to market volatility? While there may be no easy solution, a few guidelines can be helpful. If the fiduciary needs cash but only owns highly appreciated assets, the fiduciary should consider obtaining a loan to meet imminent cash needs and deferring assets sales until things settle down in 2011. If this exposes the fiduciary to too much investment risk, the fiduciary should consider acquiring a derivative security to hedge the risk. If, on the other hand, there is enough 2010 basis allocation to shelter the appreciation, the fiduciary should consider selling assets immediately to raise the cash. In either event, fiduciaries are well-advised to document everything, including the analysis that led to the decision.
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