What Is the Modified Carryover Basis Regime?
Stepped-Up Basis vs. Carryover Basis
For deaths that occurred in 2010, a decedent's heirs had the choice of applying the federal estate tax or modifying their carryover basis. This meant that the heirs had to choose between receiving an unlimited "step-up" or a limited step-up in the tax basis of their inherited property. This time period became known as the modified carryover basis regime.
What is the Tax Basis in Property?
The basis of real estate or any other asset is normally the amount paid to purchase the property, plus the value of certain capital 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 a Step-Up in Basis?
For tax years prior to 2010 and after 2010, beneficiaries of an estate are entitled to a step-up in the basis of inherited property. Regardless of what the decedent paid for the property, his beneficiary inherits at its date-of-death fair market value.
Here's an example. If a decedent paid $100,000 for a piece of real estate and did not make any capital improvements to it, and if by the date of his death the property's fair market value had increased to $500,000, his beneficiary's tax basis in the property is stepped up from $100,000 to $500,000 -- a big difference that becomes pivotal should he sell it and potentially owe capital gains tax.
What is the "Modified Carryover Basis Regime?"
A decedent's heirs had the choice of taking the full step-up in basis in 2010 or using 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 decedent's original income tax basis in the property plus the value of certain improvements, but not the full stepped-up basis.
If the decedent paid $3 million for a piece of real estate and did not make any capital improvements to it, and if the date-of-death fair market value in 2010 had increased to $5 million, the heirs would inherit the property with a carryover income tax basis of $3 million. What if the fair market value of the property 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 or into a qualified terminable interest property trust for the benefit of the surviving spouse -- called a "QTIP" trust -- could be increased by an additional $3 million.
Examples of Applying the Modified Carryover Basis Regime to a Deceased Person's Property
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 her modified carryover basis would be $5 million. The basis cannot be increased above the fair market value. A non-spouse beneficiary could only increase the carryover basis by up to $1.3 million. His modified carryover basis will be $4.3 million.
The Effect on Capital Gains Tax
If the non-spouse beneficiary sold his property with a modified carryover basis of $4.3 million shortly after the decedent's death for the fair market value of $5 million, he would owe capital gains tax on the net gain of $700,000 -- the difference between the sales price and his modified carryover basis:
Contrast this with the sale of the property when applying a full step-up in basis. The basis in the property would be stepped up to the date-of-death value of $5 million and the sale would not generate any capital gains taxes.
And if the property had an original income tax basis of $3 million and a date-of-death fair market value of $2 million? The basis inherited by the heirs would be $2 million because the basis cannot be increased above the date-of-death fair market value.