Allocation of Stepped-Up Basis
Basis for Income Tax Purposes of Assets Inherited From Decedent's Dying After December 31, 2009
Current Law
Current law applies to assets inherited from decedents dying before January 1, 2010. Until then the original basis of inherited assets is the fair market value of the assets on the date of death of the deceased, or six months thereafter if the alternative valuation date is elected by the executor. If the estate filed a Federal estate tax return this value can be taken from it. If not then the fair market value may have been reported on a state estate or inheritance tax form. Otherwise, the best available evidence of fair market value is used.
As a result of this step-up the appreciation in the value of the timber and land while owned by the deceased is not subject to income tax. No tax is due until the gain is realized by the heirs, as demonstrated in Example 1.
Example 1. Jim Smith inherited 1,200 acres of timberland from his mother. She died on October 2, 2002. The executor of her estate had the timberland appraised as of this date. The appraised value was $1,200,000. Mrs. Smith adjusted basis in the timberland at the time of her death was $120,000. If Mrs. Smith had sold the timberland just prior to her death she would owe a capital gains tax of $216,000 (20 percent of $1,200,000 minus $120,000). Jim's original basis in the timberland when he inherits it is $1,200,000. Jim sells the timberland for $1,250,000 on January 15, 2003, as soon as the estate is settled. He incurred $10,000 in sales costs. His gain would be $40,000, the sale price of $1,250,000 minus the stepped up basis of $1,200,000 minus the sales costs of $10,000. He would owe $8,000 in income tax assuming a 20% capital gains rate.
Changes Due to Elimination of Estate Tax in 2010
WARNING: Under current law the changes discussed below apply only for decedents dying in 2010. Unless Congress acts to continue these provisions the law will revert to the law in 2001 prior to enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001.
For assets transferred from decedents dying after December 31, 2009 the step up in basis rule is eliminated, except for a limited total amount to be allocated by the executor to assets they specify. The basic rule for income tax purposes will be that the basis of an asset received from a decedent is the lesser of the asset's fair market value on the decedent's date of death or the decedent's basis in the asset on the date of death. In most circumstances the basis will be the lesser of the two.
The executor can allocate a maximum of $1.3 million in stepped-up basis to estate assets transferred to any beneficiary. This amount is referred to as the "general basis increase."1 In addition, $3.0 million can be allocated to assets passing to a surviving spouse, referred to as the "spousal property basis increase."1 Thus, the total step up that can be allocated to assets transferred to a spouse is $4.3 million. Any allocated step up is added to the carryover basis, but the total cannot exceed the fair market value of the asset on the date of death, Example 2. A few of the factors to be considered by an executor in making the allocation are demonstrated in Example 3.
Example 2. Jim Smith inherited 1,200 acres of timberland from his mother. She died on October 2, 2010. The executor of her estate had the timberland appraised as of this date. The appraised value was $1,200,000. Mrs. Smith adjusted basis in the timberland at the time of her death was $120,000. The executor in consultation with Jim allocates $500,000 of the available $1.3 million to the timberland. This makes Jim's basis in the timberland $620,000, the sum of the carryover basis of $120,000 and the allocated step up of $500,000. The maximum amount that the executor could have allocated to the timberland would be $1,080,000 because the total is limited to the $1,200,000, the date of death fair market value.
Requirements to qualify for step up. Numerous conditions must be met before an executor can elect to step up the basis of an asset. These have to do with the length of time held and type of the deceased's ownership interest in the asset. Allocations to a spouse require the asset to be "outright transfer property" or " qualified terminal interest property." You should factor these requirements into your financial and estate plans in consultation with your attorney and financial planner.
Example 3. Mrs. Brown dies on January 10, 2010. Her estate included the following assets:
| Asset | Date of death fair market value |
Date of death adjusted basis |
Unrealized gain |
| Stock A, 12,000 shares | $900,000 | $45,000 | $855,000 |
| Stock B, 600 shares | $300,000 | $220,000 | $80,000 |
| Residence | $450,000 | $110,000 | n.a.2 |
| Timberland | $1,200,000 | $120,000 | $1,080,000 |
| Limited partnership interest | $80,000 | $15,000 | $65,000 |
| Total | $2,930,000 | $510,000 | $2,080,000 |
Mrs. Brown's will specifies that these assets are to be split equally among her three children, Amy, Brian, and Edith. The executor can allocate a maximum of $1.3 million in stepped-up basis to these assets. Since the assets are to be split equally the executor decides that the income tax benefits from the $1.3 million step up should also be split equally. The other way to look at this is to say that the income tax liability from the $780,000 of "uncovered gain" should be split equally. The "uncovered gain is $2,080,000 minus the $1,300,000 of available stepped up basis. This can be accomplished by deciding how the assets are to be split and then spreading the available stepped up basis proportionately. The heirs may ask the executor to factor in any differences in the their income tax circumstances and the length of time each heir expects to hold the assets inherited.
Assume that the children in consultation with the executor decide that they will each take and hold for the foreseeable future undivided interests in the timberland. None of them want the house nor the partnership interest so they ask the executor to sell them, use the cash generated to pay claims against the estate, and distribute the balance to them as cash.
On the principal that it is always best to recover basis as fast as possible they decide to allocate sufficient basis to cover the gain on the partnership, a total of $65,000. This leaves $1,235,000 to allocate to the timberland, stock A, and stock B. The children have agreed to hold the timberland, but will be making occasional timber sales. If no stepped-up basis was allocated to the timberland it would have a basis of $120,000, the carryover basis. The adjusted basis of the land, the merchantable timber account, depreciable asset accounts, etc. would all carry over as is to the children. When the children sell timber they would pay tax based on historical depletion unit.
The children tell the executor that its likely they will sell the stock before the next timber sale, the executor allocates $300,000 to Stock A for each child and $100,000 each to Stock B. This leaves $11,666.33 to allocate to the timberland for each child. Based on this information the executor reports to the IRS with the estate tax return the following allocation of assets and basis:
| Asset | Amy | Brian | Edith | |||
| Asset | Allocated Basis | Asset | Allocated Basis | Asset | Allocated basis | |
| Stock A | 4,000 shares | $300,000 | 4,000 shares | $300,000 | 4,000 shares | $300,000 |
| Stock B | 200 shares | $100,000 | 200 shares | $100,000 | 200 shares | $100,000 |
| Residence, sold by estate |
$150,000 | n.a | $150,000 | n.a | $150,000 | n.a. |
| Timberland | Undivided 1/3 interest | $11,666 | Undivided 1/3 interest | $11,667 | Undivided 1/3 interest | $11,667 |
| LP interest, sold by estate |
$26,666 | $21,667 | $26,666 | $21,668 | $26,668 | $21,667 |
| Total | $433,333 | $433,333 | $433,334 | |||
If a timber sale was likely to occur before the stock is sold consideration should be given to allocating more of the basis to the timberland. However, note that a portion of the basis allocated to the timberland will be locked up as basis in the land. The stepped-up basis allocated to the timberland must be further allocated to the land and the merchantable timber. This is done in proportion to the amount of total fair market value attributable to the land and the timber. If at the time of death the merchantable timber contributed 60 percent of the total fair market value on the date of death, 60 percent of the stepped-up basis allocated to the timberland would be allocated to the timber account.
Implications
Cost of Not Knowing Basis.
The biggest impact of the new rules is the need for records on the basis your assets. The current step-up rule provides an excuse to ignore establishing and adjusting the basis of assets you expect to hold for life. The carryover basis rules will place a burden on the executor and incur an additional expense if your estate includes assets for which no basis records can be located by the executor of you estate. The executor will be obligated to make a reasonable effort to establish the basis of all assets. How will probate judges and beneficiaries of an estate evaluate the costs incurred by an executor to search records to establish a basis against the income tax benefits realized by heirs receiving the assets.
Consider Selling Low Basis Assets.
If you have assets for which the basis is unknown or very low you might consider disposing of these before you die. This would of course require a careful evaluation of the financial implications of doing so for you, your estate, and your intended beneficiaries.
Reduced Income Tax Distinction Between Transfers by Gift and Inheritance.
Unless a beneficiary of inherited assets expects to receive a stepped-up basis allocation from the executor, they will be indifferent for income tax purposes between receiving property as a gift and by inheritance. However, the person considering a gifting program must take into account the new gift tax rules.
1. Apparently coined by Commerce Clearing House in their publications explaining the 2001 legislation.
2. Gain from the disposal of your principal residence is currently excluded from your income tax. Beginning in 2010 this treatment is extended to the sale of a decedent's principal residence if sold by the decedent's estate, the individual inheriting the residence, or certain trusts established by the decedent.