Executors of the estate of decedents who died during the 2010 have a choice between the traditional estate tax regime (i.e. $5M exemption and basis set-up) or an alternate zero estate tax/modified carry-over basis regime. The alternate regime is elective [authorized by TRA §301(c), called in Rev. Proc. 2011-41 a “Section 1022 Election”], and elected by an executor by filing Form 8939 (Allocation of Increase in Basis for Property Acquired From a Decedent).
This post is not about the pros and cons of the two systems, or even the filing requirements and deadlines for executors, but is a summary of the income tax implications of the alternate tax-free regime.
The two most important issues regarding assets inherited from an estate which made a §1022 election are the basis and holding period of the assets in the hands of the estate (if sold by the estate) or in the hands of the beneficiary (if distributed by the estate).
The application of §1022 is laid out in Rev. Proc 2011-41.
First, §1022 only applies to assets owned by the decent, as defined in §1022(d), and acquired from the decedent, as defined in §1022(e). This would generally include assets owned directly (or jointly) by a decent, any may include assets in a revocable trust owned by the decent. Also included are assets inside a trust over which the decent has a power of appointment. However, This generally excludes assets passing outside of probate (e.g. a retirement account). Asset in a QTIP trust (created by a predeceased spouse) are not considered owned by the decent [§1022(c)(5)] even though the assets are included in the decedent’s gross estate.
Under §1022, assets are generally treated as having been transferred by gift. The gift basis rules (the topic for a future post) apply to these assets [IRC §1022(a)]. This requires the executor to determine the basis in every asset owned by the decedent.
Next, sections §1022(b) and §1022(c) can apply to modify the basis of these assets. Executors have a pool of $1.3M to allocate to the various assets in the decedent’s estate (the General Basis Increase). [The basis increase available to a non-resident non-citizen decent is only $60,000.] An additional $3M may be available to allocate to certain qualifying marital property (the Spousal Property Basis Increase). The allocation is made solely by the executor, and he is not required to follow the advice or direction of any beneficiary of the estate.
The General Basis Increase under §1022(b) can be increased to the extent that there was any unused capital loss carryforward by the decent, any unused NOL, or any §165 losses. The losses available here for basis adjustment must be computed after the decent (or the surviving spouse) files the personal income tax return (covering the year of death) and the losses are first utilized on this income tax return.
The Spousal Property Basis Increase can only be applied to property which meets the additional requirement of passing to a surviving spouse. This covers both property passes outright (whether through direct bequest, or like jointly owned property passing by operation of law) as well as property covered by a QTIP election. Note that the property contributed to a QTIP trust might enjoy a basis adjustment from the estate of the first spouse to die, but will not have an additional basis adjustment from the estate of the second spouse to die.
Interesting, the Rev. Proc. 2011-14 notes that assets meet the definition of qualified spousal property if a QTIP election could be made, but does not require that the QTIP election is actually made. This creates a broad definition of qualified spousal property, which probably allows for flexibility and coordination with GST tax exemption (and state QTIP) rules, elections and allocations.
Spousal Property Basis Increase may be allocated to eligible property, even if that property is sold by the estate and not actually transferred to the surviving spouse, but only if the proceeds from the sale of such property is distributed to the surviving spouse.
Finally, the basis allocation can only raise the basis to the extent that the basis is lower than the fair market value (FMV) as of the decedent’s date of death. The basis cannot be allocated to match any increases in an assets value occurring after the decedent’s death. There is no concept of an alternate valuation date in this estate regime. The determination of FMV follows the same manner as existing rules and regulations under §2031.
There does not appear to be any requirement that an executor actually utilize the full amount of available basis adjustment, even assuming that there exist eligible assets with basis lower than FMV.
Basically, the only way for a beneficiary to know the basis of any asset if to wait for the executor to (1) determine the original basis, (2) determine how the adjustment should be allocated, and (3) report the adjusted basis to the beneficiary.
The holding period for an asset sold by the estate, or distributed to a beneficiary, includes the holding period of the decedent. Therefore, an asset held by a decedent for more than one year (prior to date of death) will be treated as long-term property when sold by the estate or a beneficiary. An asset purchased shortly before death will retain its original acquisition date; this date will be used by the seller of the property
The application of these rules is very complicated. The executor must choose the estate tax regime to apply to the decedent’s estate. If a §1022 election is made, the executor must determine the starting basis. If an asset qualifies (i.e. is acquired from the decedent) it MAY have a basis adjustment. If an asset passes to a spouse it MAY have a basis adjustment.
Because of these complications, it is required that an executor inform the beneficiary of the basis and holding period of all assets distributed. [IS THIS REQUIRED BY STATUE?] The basis allocation is documented on Form 8939 (recently issued by the IRS).
* TRA = Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Pub. L. No. 111-312, 124 Stat. 3296, H.R. 4853)