Certain decedents who passed in 2010 may have transferred assets to beneficiaries subject to a modified carryover income tax basis if the proper election was made. That income tax basis amount has to be tracked, often for many years, so that when a beneficiary eventually disposes of the received asset, s/he can report the proper amount for calculating any gain/loss. The IRS issued proposed regulations to help clarify this process.
You might think that assets passed on to beneficiaries after a decedent’s death in 2010 would be old news now in 2015, but the IRS found occasion to issue proposed regulations on May 8, 2015 that put closer attention on the short-lived modified carryover basis election. Recipients of transferred property subject to these rules need to understand the tax implications surrounding future disposition in order to plan appropriately.
As you may remember, as part of the 2001 tax cuts, the estate tax was to be repealed in full for decedents subject to the estate tax after December 31, 2009. But tax legislation enacted late in 2010 reinstated the estate tax retroactively. In recognition of settled expectations of tax professionals advising estates of decedents who had passed earlier in 2010, Congress permitted an estate executor to avoid application of the estate tax by instead opting for a modified carryover basis regime instead of the normal/ income tax basis rules in Internal Revenue Code (“IRC”) Section 1014.
IRC Section 1022, now repealed (it only applied for the 2010 tax year), applied to property acquired from a decedent who died in 2010 and made the estate election. Under that provision, property acquired from a decedent is treated as a gift. The income tax basis of the transferred property in the hands of the beneficiary/donee depends under IRC Section 1022 on whether the decedent’s adjusted income tax basis is higher or lower than the property’s fair market value (determined on the date of death). If the decedent’s adjusted income tax basis is less than or equal to FMV on the date of death, then the recipient obtains only the adjusted tax basis. However, if the decedent’s adjusted basis in the property is greater than the FMV, then the recipient’s basis is limited to the lower FMV. Congress’s goal in this alternative tax deferral structure was to let estates escape estate tax but at the price of giving beneficiaries a lower carryover basis then they would have received under the otherwise applicable estate tax’s stepped-up income tax basis provisions. With the increased state and federal combined income tax rates, this has become very important, especially in places like California, New York, and New Jersey.
Treasury and IRS felt the need to issue proposed regulations on IRC Section 1022 because even though it only affected a small number of estates in 2010 who made the election, the recipients of property subject to the election will bear the tax consequences of the carryover basis regime until all such property has been sold or disposed of at a future date. In the context of trusts (or even individuals) holding IRC Section 1022 property, that property may be held for decades (or even generations) before a sale/disposition occurs that causes the property’s tax basis to become a relevant issue.
Many of the changes proposed in the regs simply add cross-references to IRC section 1022 in instances where property tax basis is an issue. However, there are a few areas where the proposed regs detail more significant changes that taxpayers and tax professionals should be aware of. For example, in determining a credit for qualified rehabilitated buildings under Treas. Reg. Section 1.48-12, qualified expenses incurred by the decedent may decrease the transferee’s tax basis for purposes of the substantial rehabilitation test if IRC Section 1022 is involved. Similarly, the Section 1022 election can affect the use of IRC Section 179 depreciation deductions for business assets or IRC Section 267 related-party transactions, as well as the continuation of IRC section 306 stock. Basis shows up in many other areas too numerous to list here, so the proposed regs touch many code sections and provide helpful guidance and/or clarity.
On a practical note, it is good practice to make sure that any 2010 estate that made the IRC Section 1022 election give proper notice to any transferee of property of the applicable modified carryover tax basis, and any recipient of property from a 2010 estate should proactively ensure they have adequate documentation of a property’s adjusted tax basis for future tax preparation purposes.