The New Carryover Basis
by Robert L. Moshman
hould estate planners get carried away with the carryover basis? How concerned should we be about a provision that isn't arriving until 2010?
And there is no certainty that the carryover will ever arrive at all. A revision along the way is not only possible but has actually been predicted-at least by estate-planning attorneys celebrated enough to be quoted in the press and invited on talk shows.
Uncertainty is the only certainty. But while it would be more convenient to wait and see what the law actually turns out to be, any meaningful planning related to capital gains has to take place many years in advance. It is the nature of capital assets. They need time to grow in wealth. It takes time to liquidate or rearrange ownership of them.
And, from a practical point of view, clients revising a will now may not be enticed back into the planning process for many years. Assuming the carryover basis arrives on schedule, starting to plan for it in 2009 will be too late. As always, responsible planners have to deal with the actual laws on the books, regardless of the steady flow of proposed amendments. Let us therefore examine the impending rule and consider what steps various estates should be considering.
No Repeat of 1976
The last time a carryover basis was attempted in 1976, it was so problematic that Congress twice postponed it before pulling the plug on it retroactively. Nearly three decades later, we can't simply assume that Congress would allow the same fate to befall
its latest attempt to correct a discrepancy in the treatment of capital gains for assets transferred during life and those transferred at death.
Unlike the 1976 attempt, the context involves the repeal of the estate tax, which changes everything and shifts the focus of planning to the remaining taxes. Upon the repeal of the estate tax in 2010, the new carryover basis will make capital gains one of the major concerns of estate planning.
Another major reason that 2010 will not be a repeat of the aborted 1976 carryover basis is the generous step up in basis that will remain in place. The vast majority of estates, more than 99%, will not have any difficulty in transferring all of their assets to beneficiaries with a stepped-up basis using the stepped-up basis increases that will be permitted. Thus, the burden of record keeping that fell across the board is now lifted for all but the largest of estates.
Another important distinction from the failed approach of 1976 is the lead time. Instead of suddenly shifting gears, the carryover basis arrives well down the road, giving estates years to rearrange assets and secure the necessary records.
The New Approach
Under new §1022, property acquired from a decedent after 2009 will be treated as though acquired by gift. However, instead of a total carryover basis, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) allows each individual to transfer up to $1.3 million of assets at the lesser of their adjusted basis or their fair market value at the date of death.
In addition, married individuals may also transfer up to $3 million of assets to a surviving spouse. Note that various other rules apply. For example, in 2010:
The alternate valuation date of six months prior to the date of death is not applicable in this context.
The $1.3-million aggregate basis increase doesn't apply to the estates of nonresident aliens-instead a step up is limited to $60,000. The $3-million spousal property basis increase applies to estates of nonresident aliens and surviving spouses who are not U.S. citizens.
Transfers to a nonresident alien, a foreign trust, or a foreign estate will be treated as a sale based on the fair market value of the transferred asset.
Long-term-gain treatment will not be automatically afforded to property acquired from a decedent-holding periods will be relevant.
Property must be owned and acquired from a decedent. Property in a revocable trust will generally qualify, but joint ownership will mean ownership of a fractional interest.
No step up applies to property given to a decedent within three years of death unless acquired from a spouse.
Special attention must be afforded the $250,000 exclusion for gains on the sale of a principal residence. Securing this exclusion would mean a sale by an estate, a qualified revocable trust existing prior to decedent's death, or an individual inheriting the property, but not a testamentary trust.
Still Stepping Up
Knowing that larger estates will have only a limited stepped-up basis of $1.3 million for transfers to individuals and $3 million for transfers to a spouse, many current strategies will remain effective in taking full advantage of the available step ups in basis. Consider the following strategies and the discussion of the best assets for lifetime transfers and the best to retain.
Who Must Plan?: Small and moderate estates are not going to face a capital gains problem at the transferor's death. But a substantial estate can monitor the total of capital gains that will result in a given estate in 2010. If an estate is within the available amount of gains that can be stepped up in basis, assets that might otherwise be liquidated during life might be retained.
By contrast, in those estates where assets are in excess of the amount that can be stepped up in basis, some assets that have declined in value or which have poor prospects for future growth no longer need to be held in anticipation of a stepped-up basis after the owner's death.
Marital Estates
A married couple might have an estate plan that calls for assets that have appreciated in value to be transferred. At the death of the first spouse, $1.3 million of gains could then pass to heirs, while $3 million of gains could pass to a spouse. At the death of the surviving spouse, another $1.3 million of capital gains may be transferred free of tax.
That's a total of $5.6 million that a married couple can transfer at a stepped-up basis. However, note that these limits apply to the amount of appreciation, not merely the fair market value of the assets. A married couple might have $5.6 million of appreciation on assets with a market value of, say, $11 million. Moving assets of this size to reduce capital gains may be easier said than done.
QTIP Strategies: Only qualified spousal transfers are entitled to $3 million of step up in basis. Outright transfers qualify, but terminable transfers do not, with the exception of qualified terminable interest property (QTIP).
The conventional QTIP language of §2056(b)(7) is applicable. However, the executor needn't make a QTIP election for the property to qualify for a stepped up basis. Nor is it clear how the existing regulatory body of law on QTIPs will apply-since §2056 governing the marital deduction will no longer exist in 2010, the regulations on a surviving spouse's right to demand income distributions will also vanish.
A charitable remainder trust (CRT) will not automatically be treated as qualified spousal property even where the spouse is the only noncharitable beneficiary. The IRS was granted the authority to issue Regulations under which certain annuities
could be considered qualified spousal property.
Lifetime Transfers
Certain assets that will be kept in the family for generations may never be sold, or may be transferred to other family members in the future and can be covered by the limited stepped-up basis at that time. In short, trying to retrofit an estate into a distributional pattern that makes sense for purposes of the limit on stepped-up basis may trigger family frictions, litigation, and may simply not be feasible.
An audit of one's capital gains profile at any given time may reveal more than enough capital gains to require planning, yet there may be no single asset with $1.3 million of appreciation. Many appreciated assets may be earmarked for other purposes-a family home, a business, a painting.
TRANSFER LIKELY: Assets which are likely to be transferred prior to death anyway and which therefore won't be able to take advantage of the $1.3-million or $3-million step up in basis.
APPRECIATING ASSETS: Assets which are likely to appreciate in value, thereby transferring and taxing the assets before they appreciate. Such assets may include stocks and real estate.
INCOME: If the transferor has adequate income, transferring assets which bear income to individuals in lower tax brackets makes sense.
PROBLEM ASSETS: Any assets that involve a heavier administrative burden should be transferred rather than burden the executor or encumber the probate process. Assets for which the original basis may be hard to determine might fall into this category. Works of art or other objects that cannot be sold quickly or which ought to take advantage of peaks in market demand during the owner's life may also be suitable for lifetime transfers.
Retaining Assets
APPRECIATED ASSETS: At least this much hasn't changed: Assets which have appreciated in value can and should be retained, but the total of the appreciation of these assets should be limited to the size of available step ups in basis.
EXPOSURES: Assets which would be exposed to creditors of a beneficiary would be redeployed more effectively if retained.
SHRINKING VALUES: Note that certain assets such as copyrights, patents, and mineral rights tend to decline in value. These might be useful to retain in larger estates that face exposure to capital gains tax beyond the stepped-up amounts.
LIFE EXPECTANCY: An individual with a short life expectancy and sufficiently large assets would lose the stepped-up basis on any assets transferred during life.
Rethinking Strategies
Consider how much appreciation has already accrued. How much is anticipated? What is the likely disposition of each property in the future? In light of the time to prepare, a dedicated fund-a stepped-up basis shelter trust that is needed at the death of the first spouse-can be established now with appropriate assets so that $1.3 million or $3 million of appreciation can accumulate over the next 10 to 15 years and be transferred conveniently when the time comes. Several other considerations apply:
RECORD KEEPING: The carryover basis once again raises the need to have records on hand at the time of death to demonstrate the decedent's basis for appreciated assets. In the absence of such records for significant assets, a lifetime transfer of assets could be considered.
APPOINTMENT POWERS: Transferors could exercise powers of appointment in favor of themselves so that assets remain in their estates and are eligible for a stepped-up basis through December 31, 2009.
REVERSION CLAUSES: Provisions returning trust assets to the donor's estate if death occurs prior to 2010 also keeps appreciated assets in the estate while the unlimited stepped-up basis remains available.
ALLOCATION DIRECTIONS: Anticipating the dilemma facing a fiduciary in how the available stepped-up basis should be allocated, clear directions should be drafted.
EXONERATION PROVISIONS: Allocation of stepped-up basis among beneficiaries, each of whom has separate counsel, has the potential for litigation. It may therefore be relevant to consider a clause exonerating the executor or fiduciary involved.
EARMARK ASSETS FOR STEP UP: For the estate of a married couple, some thought may be devoted to designating specific assets that have appreciated enough in value to take advantage of the $1.3- and $3-million limits at the death of the first spouse and an
additional transfer of $1.3 million at the death of the second spouse. Additional strategies may concentrate on specific types of assets.
MARRIAGE: Married testators get an extra $3 million of stepped-up basis which can be applied to appreciated assets, so an individual with more than $1.3 million of capital gains could change marital status to secure a stepped-up basis for assets with $4.3 million of gains in the aggregate. In effect, the law has created a valuable incentive worth up to $600,000 for wealthy singles to get married by the end of 2009.
A Balancing Act
While there is still an estate tax, an inter vivos gift leverages whatever unified credit is available. Transferring an asset that is likely to appreciate greatly in value not only keeps the asset, but all future appreciation, out of the estate for estate tax purposes.
Once the estate tax repeal is complete in 2010, lifetime gifts will no longer be necessary to reduce the size of the taxable estate. Lifetime gifts will still serve a purpose for reducing capital gains on assets transferred at death.
Prior to EGTRRA, the likely estate tax savings generated by a lifetime transfer would have to be weighed against having to pay capital gains on the transfer of any asset instead of avoiding such tax by holding the asset until death and qualifying for a stepped-up basis.
As a result of EGTRRA, the balancing of potential taxes has to be reevaluated. Holding an asset until death (assuming the death occurs after the estate tax is fully repealed) would obviously not result in estate tax. However, all appreciation (exceeding the available $1.3- and $3-million exemptions) would be taxed.
A Rainbow Sunset
Adding yet another dimension is a sunset provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 which will act like a "reset button" in 2011. Adopted under the "Byrd Rule", the sunset provision will mean that when the
estate tax repeal finally finishes phasing in, we could be zapped back in time to the laws of 2001 in effect before the enactment of EGTRRA.
Just like that, nunc pro tunc, the estate tax would come back to life. We would have the unpleasantness of going from a $3.5-million exemption (in 2009) to a $1-million exemption (in 2011). And the tax that was repealed and no longer existed in 2010 would be back on the books in 2011 (unless Congress proactively asserts itself to prevent it).
Will the sunset provision also cause the carryover basis to revert to a stepped-up basis, or will the approach to estate taxation evolve into something that stays with the carryover basis? Somewhere, over this rainbow of possibilities, is a sunset on the horizon that is merely the beginning of the story.
TECHNICAL REFERENCES
Several resources were useful in preparing this article: Maximum use of the unified credit, The Estate Analyst (Feb., 1995); Carryover basis in 2010, Estate Planning Review (Commerce Clearing House) (Feb. 20, 2002 at p. 47); Basics of carryover basis under EGTRRA 2001, Leimberg Information Systems (online) Archive Message #384 (Feb. 12, 2002; Berall, Harrison, Blattmachr, and Detzel, Planning for carryover basis that can be/should be/must be done now, Estate Planning (WG&L) (March, 2002 at p. 99).
© K.S. 2002
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