Under the federal estate tax rules as they existed prior to January 1, 2010, the basis of property, whether real or personal, acquired from a decedent by reason of his or her death, was its fair market value on the date of death (or 6 months later, if the alternate valuation date for all assets in the estate was selected). This was called the “step-up” in basis of inherited assets.

However, as of January 1, 2010, this rule has changed. Instead, the income tax basis of property acquired from a decedent will generally be the “carryover” basis. A “carryover” basis, is the “actual cost” of the property in the hands of the decedent as of his or her date of death. There is an exception to this general rule. The Personal Representative of an estate will be able to increase the basis of estate property up to $1.3 million for property passing to non-spouse beneficiaries or $3 million in the case of property passing to a surviving spouse.

Therefore, an estate that in 2009 would not have incurred any federal estate tax because of the federal estate tax exemption for the year of $3.5 million could now, for a decedent dying in 2010, face capital gains taxes on appreciated property. If an individual dies without a spouse and an estate is valued at less than $3.5 million, if there is appreciation of more than $1.3 million, there will be capital gains taxes paid by the beneficiaries upon the sale of the assets. For example, assume that an unmarried individual purchased a house for $100,000 in 1970. The house is now valued at $900,000. Assume that the same individual owns stock which he purchased for $100,000 which is now worth $800,000. In this case, there would be appreciation in the house of $800,000 and appreciation in the stock of $700,000, for a total of $1.5 million in appreciation. Thus, $200,000 of the assets ($1.5 million less $1.3 million) would be subject to capital gains when sold. At the current long-term capital gains rate of 15 percent, this means a federal income tax of at least $30,000. In contrast, prior to 2010, if the entire estate of the individual consisted only of the house and stock, there would have been no federal estate tax and because of the step-up in basis to the fair market value of the property as of the decedent’s date of death, there would have been no capital gains tax either.

In addition, it appears that many Personal Representatives of estates in 2010 may be required to file information returns with the IRS to report this carryover and allocated basis information. It is unclear if all Personal Representatives for 2010 estates with any appreciated property will have to file these returns, or just those responsible for estates with appreciation of more than $1.3 million. The information return must be submitted with a decedent’s final income tax return. For dependents dying in 2010, the due date is April 15, 2011. The form of information return has not yet been released by the IRS.

The so-called “repeal” of the federal estate tax in 2010 will create significant federal income tax burdens and federal reporting burdens for families of decedents who never would have been subject to the federal estate tax under the prior rules.

Jeffrey C. Rambach
918-591-5202
jrambach@dsda.com