From the April 2007 issue of Wealth Manager Web • Subscribe!

April 1, 2007

Unto the Next Generation

Thanks to long-standing rules in the tax code, people who sell inherited assets that have increased in value--such as stocks, real estate and works of art--can enjoy an exceptionally beneficial tax advantage.

The reason? An inherited asset's basis is "stepped up" to its value on the date of death of the previous owner. For heirs, that means forgiveness of capital gains taxes on pre-inheritance appreciation and, on subsequent sales, tax liability only on post-inheritance appreciation. But every filing season, countless sellers of inherited assets overstate gains or understate losses because they fail to step up the bases of the assets.

Basis is simply the measure of an investment in property; this figure is subtracted from the amount received from the sale of the property to arrive at gain or loss. And don't count on the IRS to catch your clients' incorrect basis calculations. This is a do-it-yourself job.

For example, Uncle Albert writes a will that leaves appreciated stocks to niece Della. When Della receives her inheritance and sells the shares, the sale receives distinctive treatment under Internal Revenue Code Section 1014. The property's basis gets stepped up from its original cost to its value on the day Albert died. (In certain cases, an estate's executor has the option to use the property's value six months after the date of death.) Consequently, Della never has to pay any capital gains taxes on the amount the stocks appreciated while they were owned by Albert. And neither does he or his estate. Not until Della sells the stocks does any tax become due and, even then, it is levied on the post-inheritance appreciation only.

Let's say Albert originally paid $10,000 for shares worth $250,000 at his death. His will bequeathed the shares to Della, who subsequently sells them for $300,000. Because Della's basis for the property has been stepped up to $250,000, the amount she has to declare as profit is only $50,000--the increase in value between the time her benefactor died and the time she unloads the stock. Della is off the hook for any capital gains taxes on the $240,000 increase in value between the time of Albert's stock purchase and his death. Whatever he paid for the stock is irrelevant.

Another advantage for Della is that her $50,000 is a long-term gain--even if she sells the shares only a few days after Albert's death. Code Section 1223 (9) treats property received by an heir from a decedent as if it were held for more than one year.

Della's filing status and her income-tax bracket determine just how much she pays in capital gains taxes on the $50,000. There are six brackets: 10, 15, 25, 28, 33 and 35 percent. All six change continuously because they are indexed, meaning the taxable income level at which the brackets begin and end are automatically adjusted each year to reflect inflation. For 2006 and 2007, the maximum long-term capital gains rate is 15 percent for individuals in 25-percent or higher brackets. The maximum rate drops to 5 percent for anyone in the two lowest income brackets of 10 percent and 15 percent--that is, for single filers, taxable income below $30,650 for 2006 and $31,850 for 2007; for joint filers, taxable income below $61,300 for 2006 and $63,700 for 2007. There is another drop from 5 percent to zero for 2008 to 2010. (After 2010 this becomes more complex, because these rates are scheduled to "sunset" in that year.)

Now assume Della decides to hold on to her shares. That decision proves to be unwise, as the shares' value suddenly heads south, declining from $250,000 to $190,000 when she sells them and incurs a long-term capital loss of $60,000. At tax time, she is able to subtract her full loss from any gains from sales of other investments. But if there are no gains, or losses exceed gains, the law clamps a ceiling on her deduction in any one year. She can use leftover losses to offset as much as $3,000 ($1,500 each for married couples filing separate returns) against ordinary income. Beyond that, any additional losses can be carried forward indefinitely as offsets against future gains or income.

Estate taxes are also an issue, and confusion abounds about how they interplay with capital gains taxes. The step up in basis that allows Della to sidestep taxes does not help Albert's estate to escape estate taxes that are otherwise due. Just like the rest of his assets, the stock will be [estate] taxed at its $250,000 date-of-death value--not its $10,000 original cost.

Sellers of inherited assets often incorrectly calculate the amount of the step up for property held in joint ownership. On the death of the first owner, the survivor gets a stepped-up basis only for the deceased's one-half interest. There is no step up for the survivor's own interest. Couples who own their homes or other property in joint ownership with the right of survivorship often overlook the step up. This means that on the death of one spouse, the other inherits a one-half interest and automatically becomes the owner of the entire interest.

Let's suppose that John and Mary Brown paid $50,000 for stock they held in joint tenancy with right of survivorship. The shares were worth $100,000 at his death. Mary's inheritance of John's half interest means her basis increases from $25,000 (her one-half of the original basis of $50,000) to $75,000. The stepped-up $75,000 is the sum of $25,000 plus $50,000 (one-half of the date-of-death value of $100,000). On a subsequent sale, only appreciation above the $75,000 gets nicked for taxes.

When property is owned jointly with a spouse, only one-half of such property is included in the taxable estate of the first spouse to die, regardless of who paid for it. So John's taxable estate includes $50,000-- one-half of the stock's value at the date of his death, not one-half of its original cost. But the IRS exacts no estate taxes from that $50,000, thanks to an unlimited marital deduction for property left to a surviving spouse, no matter how sizable the estate.

What if John alone owned the shares? Here, too, Mary's inheritance is unencumbered by estate taxes, courtesy of the marital deduction for property willed by John to her. Even better, the stock's entire basis is stepped up to $100,000. Result: The $50,000 appreciation during ownership in his name alone escapes taxes if Mary sells for $100,000, though post-inheritance appreciation is taxed if she sells for above $100,000.

Ownership solely in John's name does not always prove advantageous. The tactic boomerangs if Mary dies first. Then there is no step up at all; John's basis stays $50,000, and a sale for $100,000 means a taxable gain of $50,000.

Capital gains taxes and estate taxes are just some of the factors that couples like the Browns need to consider when they decide how to establish ownership. For one thing, if the Browns want ownership of the entire property to be conferred automatically on the survivor, that overrides tax considerations. For another, capital gains taxes cease to be important to the Browns if the spouse who is the last to die intends to leave the property to his or her children. In that event, the stock's entire basis will be stepped up.

Moreover, the joint ownership rules do not apply if the Browns live in one of the community property states. In those nine states, there usually is a step up in basis for all of their community property. If at least one half was included in, say, John's estate, then Mary is considered to have acquired her share (the part not included in his estate) by inheritance. At the date of his death, there is a step up in basis for both his and her shares. In the previous example then, if the shares were owned as community property, the basis would step up to $100,000.

Buried in the federal tax code is a provision that forbids a step up in basis for a transfer of appreciated property from a donor to a donee when the donee dies within a year and the property returns directly or indirectly to the donor or the donor's spouse. As a result, the basis remains whatever it was at the time the donor transfers the asset to the donee. The prohibition is spelled out in Code Section 1014 (e), one small passage in the voluminous code. It contains the words that "86" a tax break for a donor who transfers property to a severely ailing donee on whose death the property then reverts back to the donor.

Despite the step up in basis for inherited property, many individuals are going to rethink decisions to hold on to appreciated assets and have them go at death to their heirs. Given the super-low rate of 15 percent for long-term capital gains--at least through 2010, for now--they might well reason that they ought to sell selected holdings now, before they die, rather than fixate on how much the step up would benefit their heirs. This tactic especially commends itself to those whose fixed-return income from interest, pensions and Social Security is insufficient to cover increasing living expenses--particularly outlays for medical care--and who have significant portfolios.

A major uncertainty is that the step up in basis is stuck in a legislative "twilight zone." Beginning in 2010 (the year that the estate tax is slated to be repealed), the law caps the amount of property eligible for a stepped-up basis, points out CCH Inc., a publisher of tax and business information in Riverwoods, Ill. Under this restriction, an estate may increase the basis of assets by no more than $1.3 million. A surviving spouse who receives assets from an estate is entitled to an additional basis step up of as much as $3 million.

If Congress does not extend the estate tax repeal, the current stepped-up basis rules go back on the books as of 2011. But the cap on the step up might be further revised or even undone between now and 2011. Stay tuned.

Without a Trace

The tax collectors lay down some meticulous rules for sale of a property left by someone who is a missing person. Here, an asset qualifies for a step up to date-of-death value only if the heir receives property from someone who is considered to have died before the sale takes place. And, says the IRS, for a missing person to be declared dead, either a court has to rule that he is dead or the assets (pursuant to a state statute) are, in effect, disposed of as though they were the property of a decedent.

If the missing person's last residence is in a state without a law that specifies the time when a missing person is presumed dead, he is considered dead after seven years of continuous absence, unless death is established earlier.

The IRS provides guidance for such situations in Revenue Ruling 82-189. Suppose Amelia von Crater disappears while on a flight over the Andes in early 2007. The search party is unable to find her or the plane. Amelia's husband, Klaus, is appointed conservator of her estate and authorized to sell real estate owned by her that had cost $40,000 originally and was valued at $400,000 at the time she vanished. Klaus sells the property before the close of 2007 and files a final joint return for that year. The return assigns a basis of $400,000 for the property.

The couple resides in a state with a presumption-of-death statute. This provides that a person is presumed dead if the individual is absent from the last known place of domicile for five continuous years, and the absence is not satisfactorily explained after diligent search and inquiry. Death is presumed to occur at the end of the five-year period unless there is evidence establishing that death occurred earlier.

The verdict: The law in Amelia's state does not presume that she is dead at the time of the sale. Therefore, there is no step up for the realty. To figure tax on the transaction, measure the sales price of $400,000 against cost of $40,000.

To gain the benefit of the step up, all Klaus has to do is delay the sale until the presumption of death takes effect.

Julian Block is a syndicated columnist and attorney based in Larchmont, N.Y.

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