Why Electing Out of the Estate Tax for Individuals Who Died in 2010 May Be the Wrong Choice

By Jerry Hesch, Esq., Of Counsel  

Carlton Fields, Miami, FL 

The purpose of this commentary is to point out that if a decedent who died in 2010 owned real estate assets where the phantom gain portion of the appreciation in value is significant, the estate may be better off by deciding to remain with the estate tax. 

For individuals who died during 2010 there exists for the first time in the history of the estate tax the opportunity to exempt a taxable estate in excess of the exemption amount from the estate tax. However, this choice comes with an income tax cost.  If a taxable estate opts out of the estate tax for 2010 decedents, there is no step-up in income tax basis under §1014 equal to the value of the appreciated assets at the time of death. Instead, the decedent's estate will succeed to the decedent's adjusted tax basis in the assets ("carryover basis") with a limited ability to eliminate up to $1,300,000 of appreciation in value for all decedents who died in 2010 and up to an additional $3,000,000 for 2010 decedents survived by a spouse.

It should be noted that the $3,000,000 adjustment to carryover basis assets for a surviving spouse does not require that the surviving spouse receive the property outright or in a QTIP trust. All that is required is that the surviving spouse receives a life estate in a trust that has title to the appreciated asset.  This adjustment is available for the assets in any trust and is not limited to the credit shelter trust or to a QTIP trust.1 

When deciding whether or not to opt out of the estate tax and into carryover basis for decedents who died in 2010, the estate advisor needs to consider whether the income tax savings from the tax-free step-up in basis at death exceeds the estate tax cost of paying the estate tax. This is especially important for assets where the liabilities exceed the income tax basis for the assets, so-called negative basis property.2  When assets with liabilities that exceed basis are sold, the amount of the gain on the sale is determined by treating both the cash proceeds and all of the liabilities as part of the sale price, thus giving rise to what is commonly referred to as phantom gain. Since the phantom gain can be eliminated if the negative basis asset is included in the gross estate upon the death of the owner, one needs to take this into account when deciding whether or not to opt out of the estate tax. The following example is designed to illustrate that in situations where the amount of liabilities in excess of basis is significant, that the income tax savings will far exceed the estate tax cost of choosing to have the estate pay the estate tax. Of course, this analysis must also take into account the decedent's other assets as the advantages of eliminating the phantom gain, and any additional gain, may be negated by the estate tax cost of these other assets.

Example: Senior died in 2010, and the executor of Senior's estate is considering whether or not to elect out of the estate tax. The principal asset in Senior's gross estate is a commercial office building held for rental. Senior purchased this property in 1984 for $20,000,000 and allocated $16,000,000 of the purchase price to the building. Senior was able to depreciate the entire amount allocated to the building over 18 years. Moreover, over the years Senior was able to take substantial funds out of the building tax-free by means of periodic refinancing. At present, the gross value, mortgage liability and adjusted tax basis for the building are:

Gross Value $54,000,000

Adjusted basis $ 4,000,000

Mortgage $44,000,000

Equity $10,000,000

Note: All of the $16,000,000 of depreciation on the building is recaptured as §1245 ordinary income. See former §1245(a)(5) which treated all buildings using an 18-year recovery period as §1245 recovery property. P.L. 97-34, §204(c).

If the executor of Senior's estate decides that the estate is subject to the estate tax, then assuming Senior's domicile at death was a state with no estate tax (and assuming no available credit against the estate tax under §2010), the estate taxes (35% × $10,000,000 equity) would be $3,500,000. And, the estate's income tax basis in the commercial office building would be stepped up, income tax-free, to $54,000,000. If the value of the land is $14,000,000, then the estate, or other successor-in-interest, can depreciate the $40,000,000 allocated to the depreciable building over 39 years (and quicker if a cost segregation study were used).

If Senior's executor elects out of the Federal estate tax so that the modified carryover basis regime applies to Senior's estate (and assuming that the available basis adjustment of $1,300,000 is used to shelter appreciation in other assets in Senior's gross estate), all of the potential $50,000,000 of gain remains, of which $16,000,000 is taxable at a Federal rate of 35%. And, all of the gain is exposed to state income taxes. Assume Senior is a resident of California with a 10% state income tax rate. If the estate sells the real estate in 2012 or 2013 for $54,000,000 (after all selling expenses are taken into account), the gain on the sale will be taxed as follows: 

 

Gain 

Combined income tax rate 

Federal and state income taxes 

$16,000,000 ordinary income

45%

$7,200,000

$34,000,000 capital gain

25%

$8,500,000 

Total

 

$15,700,000 

Selling the building is not advisable if carryover basis is elected into as the $10,000,000 of net sale proceeds after the payment of the mortgage would be far less than the $15,700,000 of income taxes on the gain.

The advantage of electing for Senior's estate to be subject to the Federal estate tax is the complete elimination of the $50,000,000 of gain, including the $40,000,000 of phantom gain (excess of liabilities over adjusted tax basis) without exposing any of the phantom gain to the estate tax. So, at an estate tax cost of only $3,500,000, the election to have the Federal estate tax apply eliminates $15,700,000 of income taxes if the property is to be sold and no like-kind exchange is used.

Even, if the property is not sold by Senior's estate, and continues to be operated as a rental property, the step-up in basis at Senior's death if the Federal estate tax applied creates an additional $40,000,000 of depreciable basis that can be taken as depreciation deductions over 39 years (and more rapidly if the depreciable building is a residential rental property or for a portion if a cost segregation study were used). Since the $40,000,000 of depreciation deductions are ordinary deductions, those deductions will save an additional $14,000,000 in taxes over the depreciable recovery period.  Thus, the present value of those future ordinary deductions must be taken into account in the analysis of whether to opt out of the Federal estate tax for this 2010 estate.

Even for buildings placed in service after 1986, the gain attributable to the straight line depreciation on the building is taxable at a Federal rate of 25% as "unrecaptured §1250 gain."

Conclusion  

When depreciable property is in the gross estate of an individual who died in 2010, one must compare the estate tax savings to the income tax costs of carryover basis, especially if the mortgage liabilities exceed the decedent's adjusted income tax basis. Even the $1,300,000 of tax-free step-up in basis permitted for carryover basis assets may be insignificant.

 For more information, in BNA's Tax Management Portfolios, see Streng, 800 T.M., Estate Planning,  and in Tax Practice Series, see ¶6350, Estate Planning. 


1 Section 1022(c)(3)(B) provides a $3,000,000 basis increase for "qualified spousal property" which includes "qualified terminable interest property." §1022(c)(5)(A)(ii).  "Qualified terminable interest property" is defined as property in trust where the surviving spouse has an income interest for life. §1022(c)(5)(B)(i). 

2 Liabilities in excess of adjusted tax basis can occur where the property is fully depreciated, especially when a cost segregation study has been implemented, the present property is the successor in a line of like-kind exchanges under §1031 or the owner has financially realized upon the appreciation in value by a series of income tax-free refinancing as loan proceeds are not taxable gain.