Recurring Proposal For Estate Beneficiary’s Basis In An Asset

There is an ongoing proposal in estate taxation to require the use of carryover basis by an inheriting beneficiary.

I am not a fan.

There is no need to go into the grand cosmology of the proposal. My retort is simple: it will fail often enough to be an unviable substitute for the current system.

You might be surprised how difficult it can be sometimes to obtain routine tax reports. I have backed into a social security 1099 more times than I care to count.

And that 1099 is at best a few months old.

Let’s talk stocks.

Question: what should you do if you do not know your basis in a stock?

In the old days – when tax CPAs used to carve numbers into rock with a chisel – the rule of thumb was to use 50% of selling price as cost. There was some elegance to it: you and the IRS shared equally in any gain.

This issue lost much of its steam when Congress required brokers to track stock basis for their customers in 2011. Mutual funds came under the same rule the following year.

There is still some steam, though. One client comes immediately to mind.

How did it happen?

Easy: someone gifted him stock years ago.

So?  Find out when the stock was gifted and do a historical price search.

The family member who gifted the stock is deceased.

So? Does your client remember - approximately - when the gift happened?

When he was a boy.

All right, already. How much difference can it make?

The stock was Apple.

Then you have the following vapid observation:

Someone should have provided him with that information years ago.

The planet is crammed with should haves. Take a number and sit down, pal.

Do you know the default IRS position when you cannot prove your basis in a stock?

The IRS assumes zero basis. Your proceeds are 100% gain.

I can see the IRS position (it is not their responsibility to track your cost or basis), but that number is no better than the 50% many of us learned when we entered the profession.

You have something similar with real estate.

 Let’s look at the Smith case.

Sherman Darrell Smith (Smith) recently went before the Tax Court on a pro se basis.

COMMENT: We have spoken of pro se many times. It is commonly described as going to Tax Court without an attorney, but that is incorrect. It means going to Tax Court represented by someone not recognized to practice before the Tax Court. How does one become recognized? By passing an exam. Why would someone not take the exam? Perhaps Tax Court is but a fragment of their practice and the effort and cost to be expended thereon is inordinate for the benefits to be received. The practitioner can still represent you, but you would nonetheless be considered pro se.

Smith’s brother bought real property in 2002. There appears to have been a mortgage. His brother may or may not have lived there.

Apparently, this family follows an oral history tradition.

In 2011 Smith took over the mortgage.

The brother may or may not have continued to live there.

Several years later Smith’s brother conveyed an ownership interest to Smith.

The brother transferred a tenancy in common.

So?

A tenancy in common is when two or more people own a single property.

Thanks, Mr. Obvious. Again: so?

Ownership does not need to be equal.

Explain, Mr. O.

One cannot assume that the real estate was owned 50:50. It probably was but saying that there was a tenancy in common does not automatically mean the brothers owned the property equally.

Shouldn’t there be something in writing about this?

You now see the problem with an oral history tradition.

Can this get any worse?

Puhleeeze.

The property was first rented in 2017.

COMMENT: I suspect every accountant that has been through at least one tax course has heard the following:

The basis for depreciation when an asset is placed in service (meaning used for business or at least in a for-profit activity) is the lower of the property’s adjusted basis or fair market value at the time of conversion.

One could go on Zillow or similar websites and obtain an estimate of what the property is worth. One would compare that to basis and use the lower number for purposes of depreciation.

Here is the Court:

Petitioner used real estate valuation sources available in 2024 to estimate the rental property’s fair market value at the time of conversion.”

Sounds like the Court did not like Smith researching Zillow in 2024 for a number from 2017. Smith should have done this in 2017.

If only he had used someone who prepares taxes routinely: an accountant, maybe.

Let’s continue:

But even if we were to accept his estimate …, his claim to the deduction would fail because of the lack of proof on the rental property’s basis.”

The tenancy in common kneecapped the basis issue.

Zillow from 2024 kneecapped the fair market value issue.

Here is the Court:

Petitioner has failed to establish that the depreciation deduction here in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.”

And …

That being so, he is not entitled to the depreciation deduction shown on his untimely 2018 federal tax return.”

Again, we can agree that zero is inarguably wrong.

But such is tax law.

And yes, the Court mentioned that Smith failed to timely file his 2018 tax return, which is how this mess started.

Here is the Court:

Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.”

Let’s go back to my diatribe.

How many years from purchase to Tax Court?

Fifteen years.

Let’s return to the estate tax proposal.

Allow for:

• Years if not decades
• Deaths of relevant parties
• Failure to create or maintain records, either by the parties in interest or by municipalities tasked with such matters
• Soap opera fact patterns

And there is why I object to cost carryover to a beneficiary.

Because I have to work with this. My classroom days are over.

And because – sooner or later – the IRS will bring this number back to zero. You know they will. It is chiseled in stone.

And that zero is zero improvement over the system we have now.

Our case this time was Smith v Commissioner, T.C. Memo 2025-24.

Thinking About The New Medicare Taxes

You may recall that Obamacare incorporated certain tax increases, albeit delayed in some cases. I have been revisiting the payroll tax changes that will kick-in in 2013. 

The High-Earnings Medicare Tax

Beginning in 2013 the employee Medicare tax will increase if the employee is high-earning, defined as $200,000 for singles and $250,000 for marrieds. One’s tax rate will go from 1.45% to 2.35%.  Remember that there is no income limit on the Medicare tax.

Note that the employee and employer will be paying different tax rates.

There are peculiar things about this tax increase. For one thing, one’s Medicare tax rate will be affected by a spouse’s income.

EXAMPLE: Al makes $175,000 and his wife makes $100,000. In 2013 their combined income is $275,000 and subjects them to the increased 0.9% Medicare tax. The tax increase is levied on the excess earnings over $250,000, which is $25,000 ((175,000 + 100,000)-250,000).

Here is the problem: how will Al’s employer (or his wife’s) know this? They won’t. The IRS has said that an employer is required to withhold only on the employee’s wages and disregard the earnings of the spouse. Therefore, as long as a married employee is below $250,000, the employer does not have to withhold the higher tax.

Here is my problem: I am going to be as popular as bedbugs when I come in at year-end and point-out the tax due to Al and his wife.

Also, since when is one’s Medicare tax affected by a spouse’s income? This is a first, to the best of my knowledge.

The Investment Income Tax

Let’s start off with the easy part: the same $200,000 and $250,000 income limits apply.

If one’s income exceeds the limit ($200,000 or $250,000), then one will have a tax hike of 3.8% on one’s net investment income. Net investment income includes interest and dividends (the classics), but it also includes net capital gains, rents (unless it is from a trade or business), royalties and some annuities. It does not include distributions from qualified retirement plans, including distributions in the form of annuities from such plans.

Let’s go with an example.

EXAMPLE: Let’s say that Jeff and Candy have combined salaries of $235,000 and combined interest and dividends of $ 32,000. Their AGI is $267,000. They have exceeded $250,000, so they are in trouble. How much is subject to the new tax? It would be the lesser of the net investment income ($32,000) or the excess over $250,000 ($17,000). Their brand-new tax for 2013 will be $646 ($17,000 times 3.8%).

Some things about this make me uncomfortable. Say that Jeff and Candy earned $213,000 instead, with the same $32,000 in interest and dividends. Their AGI is $245,000 – below $250,000 and thus avoiding the new investment income tax. However, say that they break a 401(k) to pay family medical bills or higher education expenses. Say they break $40,000. This would put their AGI at $285,000. What just happened?

Here is what happened: we have just subjected Jeff and Candy to the new tax. They will owe tax on the lesser of (1) their net investment income ($32,000) or (2) the excess of their AGI over $250,000 ($35,000). The 401(k) break just cost them $1,216 ($32,000 times 3.8%). If Jeff and Candy are under 59 ½, remember that it also cost them the 10% penalty. And income taxes on the break itself.

Again, since when have we paid Medicare tax on unearned income?

Anyway, if you are in these income ranges, you may want to start thinking about the year after next. I can immediately see the appeal of Roths and municipal bonds under this tax regime, as they will not increase one’s AGI. On a darker side, I wonder if we will see higher-income singles less willing to marry – or alternatively higher-income marrieds more willing to divorce – for tax reasons.  Taxes encourage changes in behavior. We just don’t know yet what changes these will encourage.