What Is the Modified Carryover Basis Regime?
Definition & Examples of the Modified Carryover Basis Regime
The modified carryover basis regime was a tax election that allowed heirs of decedents who died in 2010 to determine their basis in an inherited property using the lesser of the adjusted basis or the date-of-death fair market value.
Learn how the modifier carryover basis regime worked compared to how inherited property was treated under existing estate tax law, along with the rule's advantages and disadvantages.
What Is the Modified Carryover Basis Regime?
For deaths that occurred in 2010, a decedent's heirs got to choose between receiving a full step-up in the tax basis of their inherited property or a more limited tax basis known as the modified carryover basis regime.
Under the modified carryover basis regime, heirs could elect to figure their basis in a property inherited from a decedent who died in 2010 as the lesser of the adjusted basis or the fair market value of the property at the time of the decedent's death. The adjusted basis is the decedent's original income tax basis in the property plus the value of certain improvements and minus allowable depreciation, reimbursements, and losses.
How the Modified Carryover Basis Regime Works
Selling a property for more than the basis typically triggers a capital gain that is treated as taxable income. For real estate, the basis is normally the amount paid to purchase the property, plus the value of certain capital improvements. This has the effect of discouraging property owners from selling a property during their lifetime and instead holding onto it until their death. But beneficiaries aren't consigned to holding onto the inherited property, as capital gains on appreciated real estate aren't taxable once owners die.
Under federal estate tax law for tax years prior to 2010 and after 2010, property inherited from a decedent qualifies for the "stepped-up basis." That is, regardless of what the decedent paid for a property, his beneficiary inherits it at its date-of-death fair market value (whether or not an estate tax return was filed), or the fair market value on the alternate valuation date if the estate's executor filed an estate tax return and elected to use an alternate valuation date on that return. The beneficiary owes capital gains taxes only if the sale price exceeds the stepped-up basis.
For example, let's say that a decedent paid $100,000 for a property and didn't make capital improvements to it. If at the date of their death, the property's fair market value is $500,000, the beneficiary's tax basis in the property will be stepped up from $100,000 to $500,000—a big difference that becomes pivotal should they sell it and potentially owe capital gains tax. If the beneficiary sells the property for $500,000, no taxes will be due. If he sells it at $600,000, he will owe taxes only on the $100,000 difference between the sale price and the stepped-up basis rather than the original purchase price.
However, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 included provisions to repeal the federal estate tax and enact a modified carryover basis regime for decedents who died in 2010. A sunset clause in undid these provisions as of December 31, 2010. Subsequently, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (TRUIRJCA) of 2010 retroactively reinstated the estate tax and repealed the modified carryover basis rule but granted property heirs of decedents who died in 2010 the option to use the modified carryover basis regime rather than the estate tax rules.
Both the EGTRRA and TRUIRJCA shaped the modified carryover basis regime.
Opting to apply the modified carryover basis rules simply meant that the heirs could inherit the lesser of the fair market value of the decedent's property on the date of death or the adjusted basis. For example, if the decedent paid $3 million for a property, and the date-of-death fair market value was $5 million, the beneficiary would inherit the property with a basis of $3 million. If the fair market value of the property had decreased to $2 million as of the decedent's date of death, the heirs' basis in the property would be only $2 million.
The carryover basis was subject to adjustment under the modified carryover basis rules. The basis of property passing to a beneficiary other than a surviving spouse could be increased by up to $1.3 million, while property passing directly to a surviving spouse could be increased by an additional $3 million.
Using the example of a property that had an original tax basis of $3 million and a date-of-death fair market value of $5 million, a surviving spouse could increase the original income tax basis so that their modified carryover basis would be $5 million. The basis could not be increased above the fair market value. A non-spouse beneficiary could only increase the carryover basis by up to $1.3 million, making their modified carryover basis $4.3 million on the same property.
To be eligible for the modified carryover basis, the property in question generally had to be acquired by inheritance, be transferred to a revocable trust or another trust, or be another property passed from the decedent as a result of their death.
Pros and Cons of the Modified Carryover Basis Regime
The advantages and drawbacks of the tax election included:
Greater reward for capital improvements
Both spouses and non-spouse heirs benefited
More limited tax benefit compared to a full step-up in basis
Less incentive for heirs to dispose of inherited property
The advantages of the modified carryover basis regime included:
- Greater reward for capital improvements: Capital improvements to an inherited property increased the adjusted basis, which in turn increased the potential of heirs to reap tax savings from the modified carryover basis rule.
- Both spouses and non-spouse heirs benefited: Although spouse beneficiaries were able to increase their basis by more than non-spouse beneficiaries, both groups qualified under the new rules.
The tax rule had its drawbacks:
- More limited tax benefit compared to a full step-up in basis: Take the earlier example of the non-spouse beneficiary who qualified for a modified carryover basis of $4.3 million on a property with an original basis of $3 million and a date-of-death fair market value of $5 million. If they sold the property for $5 million, they would still owe $700,000 on the property. In contrast, if they got the full step-up in basis to $5 million, they would owe nothing.
- Less incentive for heirs to dispose of inherited property: The modified carryover basis meant that heirs would take on a larger tax liability than they would have incurred had they received the full step-up in basis. As a result, they might have felt the need to hold onto an inherited property, which would force them to keep real estate they didn't need or want as well as limit tax revenues for the government.
- The modified carryover basis regime was a special tax treatment concerning inherited property that was exclusively available to heirs of decedents who died in 2010.
- It granted heirs the option to use the lesser of the adjusted basis or the date-of-death full market value as the basis when calculating their tax liability on inherited property.
- It took effect as a result of the EGTRRA and was formally repealed by the TRUIRJCA.
- It granted some tax benefit for heirs by minimizing capital gains tax liability, albeit not to the extent of the full step-up in basis.