Estate taxes got far trickier for property owners January 1.

IRC §1031 as a Potential Solution for Return of Carry Over Basis in 2010

Unless Congress acts quickly, the estate tax will be eliminated from January, 2010 until Dec 31, 2010.  The failure of Congress to pass an extension of the current estate tax law is unfortunate for taxpayers.   With elimination of the estate tax comes elimination of the “stepped up basis” which currently permits taxpayers who inherit property to use the decedent’s date of death valuation as the taxpayer’s new basis.  This means that taxpayers who are selling inherited property will now pay more capital gains taxes.  However, utilizing a §1031 Exchange may be helpful in minimizing this increased tax bite.

Example 1 (2009 rules): Decedent purchased property in 1970 for $35,000.  Decedent died on Dec 1, 2009 when property was worth $500,000.  Taxpayer who inherited the property has a “stepped up” basis of $500,000 (its fair market value on the decedent’s date of death). Therefore, if the Taxpayer sells the property for $500,000 there will be no gain on the sale and no capital gains taxes due.

Example 2 (2010 rules):  Decedent purchased property in 1970 for $35,000.  Decedent died on Jan 1, 2010 when property was worth $500,000.  Taxpayer who inherited the property assumes the taxpayer’s “carry over” basis of $35,000 and inherits property with a built-in taxable gain of $465,000.   If the Taxpayer sells the property for $500,000 capital gains taxes will be due on $465,000 of gain realized by Taxpayer.

Previously, as in Example 1, taxpayers selling property they recently inherited had a 100% basis and no gain, so no need for a §1031 tax deferred exchange.  Now these inheriting taxpayers will have significant gains to shelter when they sell these inherited properties.  A §1031 exchange may be a viable solution for taxpayers who want to sell the property they have inherited and exchange, 100% tax deferred, into a property that better fits their investment objectives.   Of course, the Taxpayer must be able to demonstrate that the inherited property was held by the Taxpayer for investment or business use prior to sale in order to qualify for §1031 tax-deferral treatment.  

There has been much talk about the possibility of Congress enacting a new law in 2010 and making that law retroactive to Jan 1.  However, if the law is not retroactively remedied, the tax ramifications will be as set forth above in Example 2.  If Congress does not extend or otherwise enact a new law, the estate tax will return as of Jan 1, 2011 with a 55% estate tax rate and a return of the stepped up basis.

This information was provided courtesy of Tojia Beutler at IPX Exchange.  For more information contact me at kathryn@kjkproperties.com.