People are often surprised to learn that, for the most part, inherited assets are received income tax free. The primary exception to this general rule is income in respect of a decedent (“IRD”). IRD includes pension, IRA and 401(k) distributions, certain annuity payments and the decedent’s final paycheck. Other than IRD, most other assets received from a decedent, including the proceeds of life insurance, are received income tax free.

STEPPED-UP BASIS - THE LAW UNTIL 2010

In addition to being income tax free, the appreciation on capital assets received from a decedent is also forgiven. The tax mechanism that allows for the forgiveness of the appreciation is known as a “step-up” in basis.

A step-up in basis allows the beneficiary to sell an asset received from a decedent income tax free. In order to understand basis step-up, one must first understand the concept of “basis”.

Basis is an individual’s investment in an asset. The starting point in calculating one’s basis is to determine the asset’s original cost. For example, if Harry paid $10,000 for a stock, and sold it for $20,000, his gain would be $10,000. Harry’s amount realized ($20,000) less his basis ($10,000), equals his gain. Thus, basis is the mechanism used to measure gain or loss on the sale of an asset.

An individual’s basis in an asset can change over time. An addition to a residence, for example, would increase the owner’s basis in the residence. By contrast, the basis of rental real estate is reduced by the amount of depreciation taken by the taxpayer.

If an appreciated asset were sold prior to death, the owner would be liable for income tax on the appreciation. By contrast, the beneficiary of an asset received from a decedent receives a stepped-up basis. That is, the beneficiary is deemed to have paid the fair market date-of-death value for the inherited asset. If the beneficiary sells the inherited asset immediately, he or she would have no income tax liability with respect to such sale. A stepped-up basis eliminates any income tax consequences associated with the sale of inherited property by the beneficiary.

The combination of the stepped-up basis rules, and the income tax free nature of inheritances, generally results in no income tax to a beneficiary with respect to inherited assets (other than income in respect of a decedent). If the beneficiary sells the inherited asset at some future date, his or her gain, if any, is only the appreciation since decedent’s date of death.

The step-up basis rules were created to avoid double tax. Assets included in the decedent’s estate, the thinking goes, should not also be subject to income tax. Interestingly, the beneficiary receives a stepped-up basis even if due to the size of the estate no estate tax is actually owing.

A full step-up in basis occurs when an asset is held solely in the name of the decedent. Different rules apply where an asset is held jointly. If the joint tenant is the decedent’s spouse, the surviving spouse receives a stepped-up basis equal to one-half of the date-of-death value of the asset. This rule applies no matter which spouse supplied the original consideration needed to acquire the asset.

Assets held jointly between the decedent and a non-spouse will receive a step-up in basis to the extent that the decedent supplied the original consideration for the asset.

For example: Mom adds her son, Sam, as a joint tenant on her home for which she supplied the entire purchase price. On Mom’s death, the entire value of the home would be included in Mom’s estate, and Sam would receive a stepped-up basis equal to the entire value of the home. If Sam were to predecease his mother, Sam’s mother would not receive any step-up in basis. The residence would not be included in Sam’s estate (since he supplied no part of the purchase price), and therefore does not receive a stepped-up basis.

ALTERNATE VALUATION DATE

Rather than valuing the decedent’s property on the date of the decedent’s death, the decedent’s Personal Representative may elect to use the “Alternate Valuation Date.” The Alternate Valuation Date (“AVD”) is the date which is six months after the date of the decedent’s death. The AVD is extremely useful in situations where, shortly after death, the decedent’s assets significantly decline in value.

The impact of electing the alternate valuation date is twofold:

1. the value of the estate’s assets are reduced for estate tax purposes; and
2. the basis of assets received by the beneficiary are determined as of the AVD.

If the AVD is elected, all assets of the decedent must be valued as of the AVD. The Personal Representative cannot pick and choose which assets will be valued at death and which will be valued as of the AVD. However, any property disposed of during the six month period between date of death and the alternate valuation date will be valued (and its basis determined) as of the date of disposition.

DEATHBED TRANSACTIONS

A stepped-up basis will be denied if the property was acquired by the decedent by gift within one year of his or her death, and the property passes back to the donor at the decedent’s death. In such cases, the donor/beneficiary retains his or her original basis and cannot utilize the stepped-up basis rule. The exception prevents manipulation of the step-up basis rules for the benefit of the surviving taxpayer. Such would be the case if taxpayers were allowed to make gifts to dying people with the understanding that they would receive the gifted asset back at death with a new fair market value basis.

For example, son Sam owns property with a basis of $1,000 and a fair market value of $20,000. Sam gifts the property to Mom who is terminally ill, Mom takes Sam’s $1,000 basis. Mom dies less than one year later and leaves the property to Sam in her Will. Under the tax rules, Sam’s basis is $1,000, not $20,000, and Sam still owes tax on the appreciation.

INCOME IN RESPECT OF A DECEDENT

Income in respect of a decedent (“IRD”) is income earned by a decedent, but not paid to the decedent before death. Examples of IRD include: interest on U.S. savings bonds, deferred compensation, last pay check, bonuses, stock options, and retirement plan distributions. As noted above, beneficiaries receiving IRD must pay regular income tax at their personal income tax rate in the year of receipt. The stepped-up basis rules do not apply to IRD. To prevent double taxation, the recipient of IRD is allowed an income tax deduction equal to the portion of the estate tax paid by the decedent’s estate attributable to the IRD item.

IRD makes an ideal bequest to charity. Charities, being tax exempt, keep every dollar of such tax-burdened assets. Since IRD assets may be subject to tax at the rate of over 70% (estate tax plus income tax), they should be the first option when choosing assets to bequest to charity. It is important that IRD items be specifically referenced in the decedent’s Will or Trust as passing to the charity, or that the charity be directly named as beneficiary of the IRD item. Otherwise, satisfying a pecuniary bequest to a charity (e.g., “I leave $100,000 to the Salvation Army”) out of IRD items will generate an estate tax charitable deduction but the estate will have to include the IRD in its income.