Estate Taxes, Capital Gains, and Paperwork

By :: October 4th, 2010

The one-year lapse of the federal estate tax this year came with the unwelcome requirement that heirs assume their benefactors’ bases for some assets they inherit in 2010, as Howard Gleckman explained in a recent TaxVox post. For some mid-sized estates, that meant higher taxes. But Howard touched only briefly on the burden the new basis requirement imposes on estate executors.

Until this year—and again next year under current law—heirs received a step-up in basis along with their inheritances. That is, for the purpose of figuring capital gains taxes, their cost basis was an asset’s value at the time of a decedent’s death, rather than the original owner’s cost (including adjustments). That old model simplified estate accounting: Executors didn’t have to determine the original cost of assets, often a difficult task. Just try to figure the basis for a home bought 40 years ago so you include all of the capital improvements made over decades. Or the tax value of a family business developed with irregular cash infusions.

This is not the first time Congress has tried to impose carry-over basis—the system where heirs assume the original value for inherited assets. It adopted such a design back in 1976, only to repeal the requirement retroactively four years later in response to complaints about how hard it was to determine those original values.

For some assets, matters are much easier now. For instance, a number of commercial Websites and many brokers can figure basis for publicly-traded stock—if you know when it was first acquired and how dividends were handled. There’s no such help available for valuing many assets.

With the fate of the estate tax uncertain at best, executors still have time to work out the bases for 2010 estates. They won’t have to report values until they file an estate’s final income tax return, due next April (or a few months later with extensions). But failure to file on time can bring a $10,000 fine. In such an environment, expect a lot of guesswork.

Meanwhile the IRS appears uncertain of the requirement. I called its help line and was told twice that estates don’t have to report bases, that the IRS keeps no records on the value of inherited assets, and that people only have to report asset values when they sell the assets and pay taxes on their capital gains. Follow that advice and you’re liable for a big fine.

Until now, Congressional battles over the scheduled expiration of the 2001-03 tax cuts have drowned out complaints about carry-over basis. But the issue will surely arise in coming months. Congress will again feel pressure to undo the one-year requirement and let affected returns choose stepped-up basis. It could choose the proposal Howard reported that would give executors the option of following either 2009 or 2010 law.

Or maybe, like last year, gridlock will again paralyze the process. And this time, Congress would leave tens of thousands of heirs with a paperwork headache they were never expecting.