Dear Clients and Friends:

A frequently asked question is: For tax purposes, how is the 'cost' (or 'basis') calculated when an individual inherits property from another? This is an important area and is too often overlooked when families start to put their affairs in order.

The general rule is referred to as the 'step-up' basis rule. That is, the heir receives a basis in inherited property equal to its date of death value. For example, if Uncle Harry bought Kodak stock in 1935 for $500 and the stock is worth $5 million at his death, the basis is stepped up to $5 million in the hands of his heirs and the gain escapes income taxation.

The step-up basis rule applies to inherited property that's includible in the gross estate of the deceased regardless of whether a federal estate tax return was filed. It also applies to property inherited from foreign persons, who are not subject to U.S. estate tax. The rule applies to the inherited portion of property owned jointly with the deceased, but not the portion of jointly held property that was owned before receiving the entire property through inheritance. The step-up basis rule does not apply to reinvestments of estate assets by fiduciaries; property received instead of and in discharge of a specific bequest of money; and property of a missing person, until that person is declared or presumed dead.

It is crucial for the step-up basis rule to be understood so that disastrous tax errors are not made. For example, if, in the above example, Uncle Harry, instead of dying owning the stock, decided to make a gift of it in honor of his 100th birthday, the step-up in basis would be lost. Property that has gone up in value acquired by gift is subject to the 'carryover' basis rules: the donee takes the same basis the donor had in it (just $500), plus a portion of any gift tax the donor pays on the gift.

The basis 'step-up' rule can become a 'step-down' rule as well. That is, if a decedent dies owning property that has declined in value, its basis is lowered to the date of death value. Proper planning calls for seeking to avoid this loss of basis. In this case, however, giving the property away before death will not preserve the basis: when property which has gone down in value is the subject of a gift, the donee must take the date of gift value as his basis (for purposes of determining his loss on a later sale). The best idea for property, which has declined in value, therefore, is for the owner to sell it before death so he can enjoy the tax benefits of the loss.

Alternate valuation: Although the above discussion refers to the date of death value, the rule is different in some cases. Where the decedent's executor makes the alternate valuation election, the basis will be determined as of the date six months after the date of death (or, if the property is distributed or otherwise disposed of by the estate within the six month period, the date of distribution or other disposition).

Deathbed maneuvers: One ploy the tax rules sought to prevent was the passing of property through a decedent to attempt to inflate basis under the above rules. For example, Tim owns stock with a $1,000 basis and $20,000 value. He goes to 97-year old Uncle Vern and arranges the following: Tim makes a gift of the stock to Uncle Vern, who takes it with Tim's $1,000 basis. Vern then dies leaving the stock back to Tim in his will. Tim regains ownership, but now with the basis stepped up to its $20,000 date of death value. Under the tax rules, if Tim recovers his stock within a year of making the gift, he still has his original ($1,000) basis. The result is the same if, instead of leaving the stock to Tim, Uncle Vern leaves the stock to Tim's wife.

If you have any other questions on this topic, please call (315) 363-3338.

Very truly yours,

G. William Hatfield
Certified Public Accountant
Certified Financial Planner