1. Money
Send to a Friend via Email

What is the Modified Carryover Basis Regime?

Stepped Up Basis vs. Carryover Basis

By

For deaths occurring in 2010, the decedent's heirs will have the choice of applying the federal estate tax or making use of the "modified carryover basis regime." This means that the heirs will need to choose between receiving an unlimited "step up" or a limited step up in the basis of the inherited property. So what is the modified carryover basis regime?

What is the Basis of Property?

Before the modified carryover basis regime can be discussed, it will help to understand what the "basis" of a piece of real estate or other asset means. For income tax purposes, the basis of an asset means what was paid for the property plus the value of certain improvements. In the case of stocks and bonds, the basis simply equals the purchase price, while with real estate the basis equals the purchase price plus the value of all capital improvements.

What is the Step Up in Basis?

For tax years prior to 2010 and also after 2010, beneficiaries of an estate are entitled to receive a "step up" in the basis of the property they inherit from their deceased benefactor. A "step up in basis" means that regardless of what the decedent paid for the property, the heirs will inherit the property at its date of death fair market value. In other words, if a decedent paid $100,000 for a piece of real estate and did not make any capital improvements to it and the date of death fair market value of the real estate increased to $500,000, then the heirs will inherit the property with a stepped up income tax basis of $500,000.

What is the "Modified Carryover Basis Regime?"

For deaths occurring in 2010 only, the decedent's heirs will have the choice to either take a full step up in basis or use the "modified carryover basis regime." If the heirs opt to apply the modified carryover basis rules, then this simply means that the heirs will inherit the lesser of the fair market value of the decedent's property on the date of death or the decedent's original income tax basis in the property plus the value of certain improvements, not the full stepped up basis. In other words, if a decedent paid $3,000,000 for a piece of real estate and did not make any capital improvements to it and the date of death fair market value in 2010 increased to $5,000,000, then the heirs will inherit the property with a carryover income tax basis of $3,000,000. What if the fair market of the value of the property decreased to $2,000,000 as of the decedent's date of death? Then the heirs' basis in the property will only be $2,000,000.

Even so, the carryover basis is subject to adjustment under the "modified" carryover basis rules. Under these rules the basis of property passing to a beneficiary other than a surviving spouse can be increased by up to $1,300,000, while property passing directly to a surviving spouse or into a qualified terminable interest property trust (or "QTIP" trust) for the benefit of the surviving spouse can be increased by an additional $3,000,000.

Examples of Applying the Modified Carryover Basis Regime to a Deceased Person's Property

Using the example above of the property that has an original income tax basis of $3,000,000 and a date of death fair market value of $5,000,000, a surviving spouse can increase the original income tax basis by up to $4,300,000 so that the surviving spouse's modified carryover basis will be $5,000,000 (note that the basis cannot be increased above the fair market value), while a non-spouse beneficiary can only increase the carryover basis by up to $1,300,000 so that the non-spouse's beneficiary's modified carryover basis will be $4,300,000.

Thus, if the non-spouse beneficiary sells the property with a modified carryover basis of $4,300,000 shortly after the decedent's death for the fair market value of $5,000,000, then the non-spouse beneficiary will owe capital gains tax on the net gain of $700,000, which is the difference between the sales price and the non-spouse beneficiary's modified carryover basis:

$5,000,000 fair market value - $4,300,000 modified carryover basis = $700,000 net gain

Contrast this with the sale of the property by applying a full step up in basis, in which case the basis in the property will be stepped up to the date of death value of $5,000,000 so that the sale will not generate any capital gains taxes:

$5,000,000 fair market value - $5,000,000 stepped up basis = $0 net gain

Using the example above of the property that has an original income tax basis of $3,000,000 but the date of death fair market value has decreased to $2,000,000, then the basis inherited by the heirs will be $2,000,000 because the basis cannot be increased above the date of death fair market value.

©2014 About.com. All rights reserved.