Traps for the Unwary Regarding the Modified Carryover Basis Rules for 2010 Deaths

It still looks like we’re stuck with Internal Revenue Code Section 1022 being the tax law for estates of decedents who die during 2010.  Here are a few traps for the unwary regarding this law:

(1)  The law allows $1,300,000 of basis increase, plus an additional $3,000,000 for a surviving spouse. Increasing the decedent’s basis means somebody has to figure out the decedent’s exact basis in his/her assets. Old deeds and purchase-and-sale agreements may need to be tracked down, and a lot of tedious, time-consuming work will have to be put in on mutual funds and dividend reinvestment plans.

(2)  In addition to the $1,300,000 or $4,300,000 basis increase, additional increases are allowed if the decedent had capital loss carryovers or net operating loss carryovers. That means in some cases the decedent’s final income tax return will need to be prepared first.

(3) Assets with unrecognized capital losses as of the time of the decedent’s death cause the decedent’s estate to have additional basis increases equal to the amount of the unrecognized capital losses. There is no requirement in Section 1022 that this additional basis adjustment be utilized on the asset with the unrecognized capital loss.

(4) Internal Revenue Code Section 121(d)(11) allows the decedent’s estate, the decedent’s qualified revocable trust or the decedent’s beneficiary (as defined under Section 1022) to utilize the decedent’s $250,000 capital gains exclusion on a sale of the decedent’s principal residence. There does not appear to be any time limitation on the usage of this exclusion, so in some many cases it could be wasteful (and legally actionable) to use the Section 1022 basis increase on the decedent’s principal residence without taking Section 121 into account.  This means that the basis adjustment for many estates without surviving spouses under 2010 law can effectively be $1,550,000.

(5) Under Internal Revenue Code Section 6716, there is a $10,000 penalty for failure to file Form 8939 on a timely basis.

(6) Form 8939 is due at the time of the decedent’s final income tax return, so in many cases placing Form 1040 on extension may be advisable to give the Executor more time to gather all the necessary information for Form 8939.

(7) Beneficiaries are required to be sent information about the basis increase within 30 days after Form 8939 is filed. Failure to do so can result in a $50 penalty per beneficiary.

(8) Only an “executor” can allocate the basis increase, and that term is not defined within Section 1022, but under Treasury Regulation 20.2203-1, the term “executor” includes an executor or administrator, but if there is no executor or administrator, the term means “any person in actual or constructive possession of any property of the decedent, ” and the term can actually include “the decedent’s  agents and representatives; safe-deposit companies, warehouse companies, and other custodians of property in this country; brokers holding, as collateral, securities belonging to the decedent; and debtors of the decedent  in this country.”  Thus, the lack of an executor or administrator being appointed for a decedent’s estate can mean the possibility exists for different persons or entities to file competing Forms 8939 with different basis adjustments (and perhaps the first one filed wins).

(9) It is possible that the Executor’s basis allocation decisions on a timely-filed Form 8939 may be final, binding and unamendable even  if self-serving, biased or irrational.

(10) Where the date that the decedent acquired the property is required, Executors and their accountants may find that attempting to list the separate purchases made in dividend reinvestment plans to achieve a step-up in basis on each investment may not be worth the time and effort.

(11) The first version of Form 8939 withdrawn by the IRS did not require an explanation of why the Executor of the estate believes the asset would be entitled to a step-up in basis under Internal Revenue Code Section 1022. Thus, technical issues as to whether life estates, reserved powers of appointment or irrevocable trusts are “owned by the decedent” and “received from the decedent” under Internal Revenue Code Section 1022 may not be flagged except, perhaps, where an “[a]ccurate description of the property” is required. Even though the basis of an asset is a question of fact that the IRS can later bring up, a decision will have to be made as to how much information to include on Form 8939.

(12) Filing Form 8939 may make sense even for smaller estates, to help the beneficiary prove to the IRS (when selling the asset received from the decedent) that the estate did not exceed $1,300,000.

(13) It is possible, but not certain, that filing Form 8939 will begin the 3-year clock against the IRS on valuation issues.

(14) Internal Revenue Code Section 1022 has specific safe harbor provision for qualified revocable trusts but not for revocable trusts. (A qualified revocable trust is simply a revocable trust that is elected to be treated as part of the decedent’s estate for income tax purposes under Section 645(b)(1).) To be conservative and assure the possibility of a step-up in basis for assets held in a revocable trust for someone who dies during 2010, it seems that the Executor of the decedent’s probate estate and the Trustee of the decedent’s revocable trust should make the election under Section 645(b)(1) to treat the trust as a qualified revocable trust for income tax purposes.