What Tax form do I use for Deaths in 2010.

While there is no estate tax in 2010, there is still a tax form to be filed with the federal government in relation to the estates of people who died in 2010.  As discussed in greater detail here, where a person has died in 2010 their executor has an opportunity to allocate $1.3 million to the basis of their assets (plus an additional $3 million for assets passing to a surviving spouse).  The great question is "How?".

We tax attorneys are good at following the often complicated rules the IRS lays out, but here there is a total absence of direction.  The IRS has promised to issue a new Form 8939 to allocate basis as set forth in 1022 of the Code.  However, this is what the website for that form currently says:

Form 8939 in Development
Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent, is in
development and will be posted here shortly. Disregard all prior drafts.  

Not exactly helpful.  

So what is an Executor or Personal Representative to do to meet their tax filing obligations where a person died in 2010?  Our office is preparing a spreadsheet with all the information required under Section 1022 and having it attached to the decedent's final 1040 being filed April 15, 2011.

 

Estate Tax Update - A Choice of Tax Law to apply for deaths in 2010

The Wall Street Journal reports that the Senate is sending out legislation to allow estates of people who died in 2010 to choose EITHER the 2010 1022 basis election OR the 2011 estate tax laws, which are currently proposed to be a $5 million exemption per person and 35% estate tax.

Legislation taking shape in the U.S. Senate to extend expiring tax cuts would give heirs of wealthy people who died this year a choice of which estate-tax policy to apply, according to an aide close to the discussions.

Estate executors could choose to apply the rules in place this year, in which there is no federal estate tax, or the rules that would take effect next year imposing a 35% tax rate on estate wealth over $5 million.

The ability to elect either 2010 or 2011 rules would help certain heirs of those who died this year. Even though there is no estate tax, some assets inherited in 2010 face capital gains or other taxes because of a change in the way the value of those assets is calculated.

This would be a whole new issue for estates of people who died in 2010, creating both opportunities to save tax, and potential pitfalls if timely elections and filings are made (and of course, no word on what would be timely).

 

Image: Idea go / FreeDigitalPhotos.net

2010 Tax Basis Rules and Medicaid Planning - What happens to my Life Estate?

The estate tax changes in 2010 are not only playing havoc with estate plans, but asset protection planning for those concerned with long term care costs as well. I came across this informative article "Which Pre-2010 Medicaid-Oriented Transfers of Homes Get a Step-up in Basis under the Modified Carryover Basis Rules?" by Massachusetts attorney Brian E. Barreira.

For deaths in 2010 there is not an automatic step up in basis (see my prior post on the impact of 2010 estate tax law changes on basis).  Instead, a decedent' estate can add $1.3 million (for a single person) or up to $4.3 million (for a married person) to the basis of inherited assets.  Brian describes the situation as follows:

Under the applicable 2010 tax law, known as the modified carryover basis rules, an estate can opt for a step-up in basis for certain assets, and to see whether these are eligible, Internal Revenue Code section 1022 applies. The most common types of transfers of the home that were made for Medicaid planning purposes in the past were (1) joint tenancy with right of survivorship, (2) a reserved power of appointment in a deed, (3) an irrevocable income-only trust, which often includes a reserved power of appointment, and (4) a reserved life estate, use-and-occupancy agreement or informal understanding. To qualify for the step-up in basis, an asset must be owned under Section 1022(d) and acquired under Section 1022(e), so each type of transfer must be analyzed.

Internal Revenue Code section 1022 (d)(1)(B)(i) allows at least a partial step-up for some joint tenancies; (d)(1)(B)(iii) denies the step-up for a reserved power of appointment, presumably only in a deed. Section 1022(e)(2)(B) allows the step-up for some irrevocable trusts, including a power to alter or terminate the trust, which would seem to include a reserved power of appointment in an irrevocable trust. "

Brian cautions however that a transfer with a reserved life estate may have a different result for deaths in 2010:

It has been questioned whether a life estate is entitled to a step-up in basis. Several blog commentators have written that a life estate is not eligible for the step-up, but many of them seem to be parroting each other and not displaying their analysis. Section 1022(e)(3) seems to include a reserved life estate but not a use-and-occupancy agreement or informal understanding. The language in (e)(3) includes “property passing from the decedent by reason of death to the extent that such property passed without consideration,” and where the property passes to the remainderpersons upon the life tenant’s death, that description could include a reserved life estate. Further, under Massachusetts law, the life tenant has exclusive possession of the entire property during the life tenant’s lifetime, and may therefore fit the ownership test in Section 1022(d). Thus, it appears to me that a Massachusetts life estate can be eligible for a step-up in basis."
 

NAELA (National Association of Elder Law Attorneys) is currently seeking guidance from the IRS that basis under Section 1022 can be allocated to property transferred as a result of a life estate.  

Image: Francesco Marino / FreeDigitalPhotos.net

"Death" of Estate Tax in 2010 creates Tax Trap for Spouses

My prior post was about the federal tax impact for single individuals who die in 2010 (unless Congress does as they have promised and create an estate tax retroactive to January 1, 2010 – we will have to wait and see if that happens and how it is constructed).

The news for single folks was not good. Mom dying with a $3.5 million estate in 2009 could leave it to son tax free. Mom dying with that same $3.5 million dollar estate, assuming the basis of her assets is $350,000, now creates a  federal capital gains tax of $277,500 for son (or $416,250 if he is in NJ).

The news for married folks is worse. In 2009 mom could leave $100 million (or whatever amount) to dad with no taxes whatsoever – there is an unlimited marital deduction from estate taxes (so long as your spouse is a US citizen). In 2010 only $4,300,000 will pass tax free to the surviving spouse.

The "death" of the estate tax creates a capital gains "trap" - and the “trap" catches assets passing to a surviving spouse that were never subject to tax under the estate tax.

What??? you say. How is it possible that by eliminating the estate tax you are creating a tax for widows and widowers? As I noted, due to the magic of Internal Revenue Code Section 1014, capital gains taxes disappear at death under the 2009 law. Section 1014 creates a “step-up in basis” by stating that when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, and when she dies it is worth $100.  Dad  inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).

However, in 2010 there will be no estate tax, and therefore no “step-up in basis”.  Instead, per Section 1022, Dad can apply $1,300,000 million plus $3,000,000 to add basis to the assets that mom has. How might this work? Let’s say mom has a $6 million estate, made up mostly of the family business she and dad still work in and some real estate. Assume mom has a $500,000 basis in the assets – all that appreciation has been due to increases in value over the years. If mom died in 2009, dad would get $6 million tax free. If mom dies in 2010, and dad sells everything since he doesn’t want to work without his life partner, he only has a basis of $4,800,000  ($500,000 of mom’s basis + $4,300,000 of allocated basis). Since he sold for $6 million, he has $1,200,000 of capital gains. He will owe the federal government $180,000, and if he lives in New Jersey, he will also owe the Garden State $90,000, for a total of $270,000. Remember, had mom died in 2009 when there was an estate tax in place, dad would have owed $0.

It bears repeating that all other concerns aside, this new tax regime where you need to track cost basis over a life time is a nightmare. How do you prove mom’s basis before she died was $500,000? Was every improvement tracked? What documentation will the IRS accept as proof? Will you have that documentation 30, 40, 50 years later?

My next post will address some planning opportunities (every cloud has a silver lining after all) that might exist in this new tax environment.

Federal Estate Tax "Death" in 2010 Creates Capital Gains Trap

Sigh ... I was really, really hoping I would not have to post about what happens to those who die in 2010 from a federal tax perspective.  However, since Congress couldn't seem to get its act together, here is the current 2010 landscape (with the caveat that Congress can act in 2010 and have a retroactive estate tax - but, we will have to see what happens when it happens).

Did you know that the "death" of the estate tax creates a capital gains "trap"?  And that "trap" catches the smaller estates, the ones that under current tax laws have no federal tax consequences on death. 

Assume you are single person with a $3.5 million estate (I will post separately about married couples).  Had you died in 2009, there would have been no federal tax consequences to your death.  If you die in 2010,  there will no federal estate taxes (same as 2009).  However, your heirs will have to pay capital gains taxes (see, there is always a catch).

What??? you say.  I thought death was tax free in 2010.  It is estate tax free, there won't be a federal estate tax.  There will, however, be federal and state capital gains taxes for deaths in 2010. Why??? you ask.  Well, there is a pesky little section of the Internal Revenue Code (1014) that says, essentially - when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, when she dies it is worth $100.  Son inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).  Section 1014 is a neat magic trick - it makes capital gains taxes disappear.  In tax parlance we call this a "step-up in basis".

However, in 2010 there will be no estate tax, and therefore no step-up in basis.  Let's take the same example where mom bought stock for $10, and when she dies it is worth $100.  Son inherits stock and sells for $100.  He now has a capital gain of $90 subject to tax ($100 of value - $10 of basis = $90).  He must pay federal capital gains tax on this amount (15%) and state capital gains tax (7.5% in New Jersey) for a total tax of $20.25 if he is in NJ - or $15 if he is in FL or another state without a state estate tax.  

Notice that when mom died in 2009 with an estate tax in place, son netted $100.  However, when mom dies in 2010 with no estate tax in place, son only nets $79.75. Lets add some zeros - son nets $1,000,000 if mom dies in 2009, but only $797,500 if she dies in 2010.  Now you see how no estate tax is not necessarily a good thing?!

The above is over-simplistic, but it makes the point that the "death" of the estate tax creates a capital gains trap.

One point of "relief" - your estate will be able to allocate $1.3 million to add basis to inherited assets (different rules apply for a surviving spouse) per code Section 1022.  To continue our example, mom's entire $3.5 million estate consists of stock she bought for $10 a share and is now valued at $100 a share.  Her cost basis in her estate is $350,000.  She dies, and the estate has an additional $1.3 million of basis - so the stock now has a total basis of $1,650,000.  Son sells the stock for $3.5 million, creating a capital gain of $1,850,000, which in return has son paying a federal capital gains tax of $277,500 (or $416,250 if he is in NJ).  Remember now, if mom had died in 2009 when there was a federal estate tax, son would have paid $0 in tax.

But the the so called "relief" is a trap too - how are you going to prove basis?  How do you know what mom paid for each stock share?  And if you do know, what about splits, mergers, stock dividends - what is her cost basis in all those?  Tracking basis for assets acquired over a person's lifetime, particularly when the person is now dead, is a nightmare.

Congress has "promised" to reinstate the estate tax to January 1, 2010 - and I think we all know what weight to give to Congresses promises.

My next post will address what happens if mom dies in 2010 survived by dad  (a spouse) - and the picture isn't rosy there either.