Generally, property inherited from a decedent gets a basis equal to the property's fair market value on the date the decedent died. This rule applies regardless of whether a federal estate tax return is filed.However, the fiduciary of the decedent's death can elect to value all the property includible in the decedent's estate on the alternate valuation date, but only if that will result in a decrease in both:
* The value of the gross estate; and,
* The sum of the estate tax imposed on the decedent's estate and the generation-skipping transfer tax imposed on property included in the decedent's gross estate.
Observation: This means that estates that owe no federal estate tax or GST tax cannot elect alternate valuation. This rule prevents estates that have no estate or GST tax liability from making an alternate valuation election in order to get an increased income tax basis for property that appreciated in value in the six months after the decedent's death, if this increase did not result in an increased transfer tax cost.
If the alternate valuation date is available and is elected, the basis of the property equals its value on the earlier of the date that is six months after the decedent's death, or the date that the property is distributed or sold.
Property treated as acquired from the decedent. In addition to property acquired by bequest, devise or inheritance from a decedent, and property acquired by the decedent's estate from a decedent, the following items of property required to be included in the decedent's gross estate for federal estate tax purposes are also treated as acquired from a decedent.
1. Property that was given as a gift within three years of the decedent's death.
2. Property that the decedent transferred during his lifetime in trust to pay the trust income to, or on the order or direction of, the decedent if the decedent reserved either:
* The right to revoke the trust at all times before his death; or,
* The right to make any change in the enjoyment of the trust through the exercise of a power to alter, amend or terminate the trust (done alone or with the consent of another person who did not have an interest adverse to the decedent).
Observation: If property described above is disposed of before the decedent's death, the property isn't treated as acquired from the decedent, and the basis of the property is determined under the gift tax rules. However, property received in exchange for such property, and property acquired through reinvesting the proceeds from the sale of such property (and property received in further exchanges or reinvestments) is treated as acquired from the decedent.
Example 1: Your client's father gave her 1,000 shares of stock in Dauntless Corp. on Dec. 15, 2004. Her basis in the stock was $20,000. She sold the stock on Jan. 10, 2005, for $50,000 and recognized a gain on the sale of $30,000. She used the $50,000 proceeds from the sale of the Dauntless stock to buy 2,000 shares of Evermore stock on Jan. 11, 2005. Her father died on May 1, 2005, when the fair market value of your client's Evermore stock was $55,000. The Evermore stock will be treated as acquired from her father, so that she will get a stepped-up basis in the stock to its value on the date of his death.
3. Property that passes without full and adequate consideration under a general power of appointment exercised by the decedent in his will.
4. Property that a person acquires as the surviving tenant by the entireties or as the surviving joint tenant (or one of two or more surviving joint tenants) is property acquired from a decedent to the extent that the property is includible in the gross estate of the deceased joint tenant.
Observation: If property was acquired by the decedent and the other co-owner or owners by gift, will or inheritance, only the decedent's fractional share of the property is included in the decedent's gross estate. If the joint ownership was created by one or more of the co-owners, the entire value of the property is included, except the part attributable to the consideration furnished by the other co-owners. However, if the joint interest was created and owned by spouses, half the value of the property is included in the gross estate of the first spouse to die, regardless of which spouse paid for the property.
5. A surviving spouse's share in community property is treated as property acquired from the decedent spouse if at least one-half of the community property was includible in the deceased spouse's estate.
Observation: This means that both the surviving spouse's share of the community property and the decedent's share are treated as property acquired from the decedent, and thus both shares get a date-of-death fair market value as their basis (unless the alternate valuation date value is available and is elected).
Property that is not treated as acquired from the decedent. The following are not treated as acquired from a decedent, and thus do not get a new basis based on fair market value as of the date of the decedent's death (or the alternate valuation date, if available and elected):
1. Income in respect of a decedent. This covers income (including capital gain) that a decedent had a right to receive but that:
* Wasn't actually or constructively received by a cash basis decedent; or,
* Wasn't accrued by an accrual basis decedent.
Income in respect of a decedent includes taxable distributions from a qualified employee plan or IRA; partnership income of a deceased partner; S corporation income of a deceased shareholder; insurance renewal commissions; a pension paid to the decedent's survivor; interest accrued through the date of the decedent's death; and dividends payable after the decedent's death to a holder of record before the decedent's death.
Observation: Capital gain realized on the sale of property before the decedent's death that is not taken into account until after the decedent's death, e.g., where an installment sale of property is made, would be income in respect of a decedent.
2. Property transferred by the administrator or executor to a beneficiary in satisfaction of a specific pecuniary bequest. The beneficiary's basis is the fair market value of the property on the date of the transfer.
Example 2: Your client's mother left him a bequest of $500,000 in her will. The executor of his mother's estate distributed cash of $300,000 and stock with a fair market value of $200,000 on the date of distribution to your client in satisfaction of the bequest. The stock had a basis to the estate of $170,000, its fair market value on the date of your client's mother's death. The estate will recognize a gain of $30,000 on the distribution of the stock to your client (fair market value of $200,000 less basis to estate of $170,000), and your client's basis in the distributed stock will be $200,000.
3. Property that the fiduciary acquires after the decedent's death. Its basis to the estate (or a distributee, if it's distributed) is its cost or other basis with appropriate adjustments.
4. Property bought from the decedent's estate. Its basis to the buyer is its cost or other basis with appropriate adjustments.
Property acquired from a decedent that does not get a new basis equal to fair market value on the date of death or alternate valuation date. The following items of property acquired from a decedent do not get a new basis based on the fair market value of the property on the date of the decedent's death, or on the alternate valuation date if available and elected:
1. Property acquired by gift by the decedent during the one-year period ending on the date of the decedent's death, if the property is acquired from the decedent by the donor or the donor's spouse.
2. Special use property. If a fiduciary elects for estate tax purposes the special use valuation method of valuing farm or other closely held business property included in the decedent's gross estate, the basis of the real property is its value determined for purposes of the special use valuation election (rather than fair market value).
3. Land subject to a qualified conservation easement. To the extent that the value of land subject to a qualified conservation easement is excluded from the gross estate, the basis of the land acquired at death is a carryover basis.
Example 3: Your client's uncle died having made a conservation easement on some woodlands that he owned, and his executor elected the exclusion for qualified conservation easements. The fair market value of the property on the date of your client's uncle's death was $750,000.
The amount of the exclusion is $300,000. The basis of the property in the decedent's hands was $250,000. Therefore, 40 percent of the property ($300,000/$750,000) would receive a carryover basis of $100,000, and 60 percent would receive a date-of-death basis of $450,000, for a total basis of $550,000.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
