The Consistent Basis Rule

 

I was talking to two brothers last week who are in a partnership with their two sisters. The partnership in turn owns undeveloped land, which it sold last year. The topic of the call was the partnership’s basis in the land, considering that land ownership had been divided in two and the partnership sold the property after the death of the two original owners. Oh, and there was a trust in there, just to add flavor to the stew.

Let’s talk about an issue concerning the basis of property inherited from an estate.

Normally basis means the same as cost, but not always. Say for example that you purchased a cabin in western North Carolina 25 years ago. You paid $250 grand for it. You have made no significant improvements to the cabin. At this moment your basis is your cost, which is $250 grand.

Let’s add something: you die. The cabin is worth $750 grand.

The basis in the cabin resets to $750 grand. That means – if your beneficiaries sell it right away – there should be no – or minimal – gain or loss from the sale. This is a case where basis does not equal cost, and practitioners refer to it as the “mark to market,” or just “mark” rule, for inherited assets.

There are, by the way, some assets that do not mark. A key one is retirement assets, such as 401(k)s and IRAs.

A possible first mark for the siblings’ land was in the 1980s.

A possible second mark was in the aughts.

And since the property was divided in half, a given half might not gone through both marks.

There is something in estate tax called the estate tax exemption. This is a threshold, and only decedents’ estates above that threshold are subject to tax. The threshold for 2024 is $13.6 million per person and is twice that if one is married.

That amount is scheduled to come down in 2026 unless Congress changes the law. I figure that the new amount will be about $7 million. And twice that, of course, if one is married.

COMMENT: I am a tax CPA, but I am not losing sleep over personal estate taxes.

However, the exemption thresholds have not always been so high. Here are selected thresholds early in my career: 

		Estate Tax
Year		Exclusion
1986		500,000
1987- 1997		600,000
1998		625,000

I would argue that those levels were ridiculously low, as just about anyone who was savings-minded could have been exposed to the estate tax. That is – to me, at least – absurd on its face.

One of our possible marks was in the 1980s, meaning that we could be dealing with that $500,000 or $600,000 estate threshold.

So what?

Look at the following gibberish from the tax Code. It is a bit obscure, even for tax practitioners.

Prop Reg 1.1014-10(c):

               (3) After-discovered or omitted property.

(i)  Return under section 6018 filed. In the event property described in paragraph (b)(1) of this section is discovered after the estate tax return under section 6018 has been filed or otherwise is omitted from that return (after-discovered or omitted property), the final value of that property is determined under section (c)(3)(i)(A) or (B) of this section.

(A) Reporting prior to expiration of period of limitation on assessment. The final value of the after-discovered or omitted property is determined in accordance with paragraph (c)(1) or (2) of this section if the executor, prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, files with the IRS an initial or supplemental estate tax return under section 6018 reporting the property.

(B) No reporting prior to expiration of period of limitation on assessment. If the executor does not report the after-discovered or omitted property on an initial or supplemental Federal estate tax return filed prior to the expiration of the period of limitation on assessment of the tax imposed on the estate by chapter 11, the final value of that unreported property is zero. See Example 3 of paragraph (e) of this section.

(ii) No return under section 6018 filed. If no return described in section 6018 has been filed, and if the inclusion in the decedent's gross estate of the after-discovered or omitted property would have generated or increased the estate's tax liability under chapter 11, the final value, for purposes of section 1014(f), of all property described in paragraph (b) of this section is zero until the final value is determined under paragraph (c)(1) or (2) of this section. Specifically, if the executor files a return pursuant to section 6018(a) or (b) that includes this property or the IRS determines a value for the property, the final value of all property described in paragraph (b) of this section includible in the gross estate then is determined under paragraph (c)(1) or (2) of this section.

This word spill is referred to as the consistent basis rule.

An easy example is leaving an asset (intentionally or not) off the estate tax return.

Now there is a binary question:

Would have including the asset in the estate have caused – or increased – the estate tax?

If No, then no harm, no foul.

If Yes, then the rule starts to hurt.

Let’s remain with an easy example: you were already above the estate exemption threshold, so every additional dollar would have been subject to estate tax.

What is your basis as a beneficiary in that inherited property?

Zero. It would be zero. There is no mark as the asset was not reported on an estate tax return otherwise required to be filed.

If you are in an estate tax situation, the consistent basis rule makes clear the importance of identifying and reporting all assets of your estate. This becomes even more important when your estate is not yet at – but is approaching – the level where a return is required.

At $13.6 million per person, that situation is not going to affect many CPAs.

When the law changes again in a couple of years, it may affect some, but again not too many, CPAs.

But what if Congress returns the estate exemption to something ridiculous – perhaps levels like we saw in the 80s and 90s?

Well, the consistent basis rule could start to bite.

What are the odds?

Well, this past week I was discussing the basis of real estate inherited in the 1980s.

What are the odds?

Let's Tax The Rich At 100%

I am a huge fan of Warren Buffett - when it comes to investing. You may remember that he not long ago called for raising the tax rates on the rich and uber-rich, as it was unfair that he paid a lower tax rate than his secretary. Personally I hear that comment as an argument for a flat tax, but he went in a different direction.

He proposed raising taxes on those earning more than $1 million, with yet more taxes for those earning more than $10 million.

That beggars the question: what difference would it make? I could go to the theater every day, but it would not make me a movie star.

The Tax Foundation went to the IRS itself for statistics. They were curious what the result would be if the government confiscated ALL the income of those earning $10 million or more.

Here is the result:

Source: Tax Foundation

All that, and we would reduce the deficit by only 12% and the national debt by 2%? But I suspect that you already knew the answer, didn't you?

Laurel and Hardy Dancing on the Fiscal Cliff

I personally would prefer Laurel and Hardy to what we have up there presently. 

What Will The Tax Cliff Cost You?

The Tax Foundation has published an analysis on the impact of the tax cliff on a typical family in each state.

To arrive at the typical family, the Tax Foundation used Census and IRS data to estimate income and deductions for an average two-child family in each state.

They then ran those numbers through two tax calculations: the first using 2011 tax law, and the second using projected 2013 law. The rub of course is the 2013 law, as Bush-era and Obama tax cuts are expiring. It is unknown what, if anything, will take its place. This is the “taxmaggedon” you may have read about. Another key piece to 2013 is the alternative minimum tax (AMT), as the most recent AMT “patch” expires with the 2012 tax year.

The rankings go from #1 to #50, and one does not want to be #1. That dubious distinction goes to New Jersey, not exactly an economical place in which to live under the best of circumstances.

In our corner of the world, the TriState area (Ohio, Kentucky and Indiana) came in as follows:

                                                $ Increase                                 % Increase

Ohio                                          $3,437                                       4.72%

Indiana                                     $3,653                                       5.27%

Kentucky                                  $3,437                                       5.18%

So – if the politicians accomplish nothing – the tax cliff will cost the average TriStater approximately $300 per month. This is real money, folks.

Taxmaggedon

You may have read or heard about the “fiscal cliff” and “taxmaggedon.”

There are a couple of things going on here. Taxmaggedon refers to tax increases and the fiscal cliff refers to the federal budget and sequestration. The combination of the two is slated to happen in less than 3 months unless Congress and the White House act.

Let’s talk about the taxes.

There were revisions made to the tax code back in 2001 and 2003. These revisions have become known as the “Bush tax cuts,” which seems a reasonable description, and the “temporary tax cuts,” which doesn’t seem so reasonable. My daughter was in elementary school back when these tax changes were made. Today she is in college. To refer to these tax cuts as “temporary” is an abuse of the language.

Congress’ new thing is to put an expiration on tax legislation. It is somewhat like getting married but giving your spouse a term of only 5 or 7 years. At that date the marriage would be reviewed and – if found advantageous – would be extended for another period. I suppose one could stretch such a marriage out for many decades, but it seems bad form. Congress however seems to think that this is a fine way to pass tax law.

 A lot of tax law is expiring very soon. When it does, chances are that your taxes are going up. Why? There are a few items in there that we have come to take for granted, and by “we” I mean ordinary people who set an alarm clock and leave for work every day. Here are some examples:

(1)    Do you like your 10% individual tax rate? Well, that rate is going away. Sorry.

(2)    Have you managed to stash a couple of dollars in a mutual fund for your kids’ education? Tax on the dividends from that mutual fund will no longer be capped at 15%. Only rich people have mutual funds anyway.

(3)    Remember the tax marriage penalty? That used to mean that two people – if married – pay more taxes than if they had remained single. The penalty is back.

(4)    Are you selling that mutual fund when your kid starts college? If you have a gain, your tax is going up. See (2) above about owning mutual funds.

(5)    Certain credits, such as the education credits, will be reduced. The child credit, for example, will drop from $1,000 to $500 per eligible child.

(6)    Your social security withholding will increase from 5.65% to 7.65%.

Is it going to happen? I have no clue. But if it does, it will not be confined only to the “rich.” It will be all of us – at least, those of us who still pay taxes. That is one of the things that the “Bush tax cuts” did, by the way: remove millions of people from the tax rolls. There was debate at the time whether it was beneficial for society to divorce so many people from contributing to everybody’s government. It will be gallows humor to see the politicians tap dance when those millions return to the tax rolls.

Paying a Fair Share Act

U.S. Senator Whitehouse (D-R.I.) has introduced a tax bill named the Paying a Fair Share Act.

This is the Buffett Rule. It would apply only to taxpayers with income over $1 million. At income levels over $2 million, there would be a flat 30% tax. At income between $1 million and $2 million there would be a phase-in to get the effective tax rate to 30%.

The bill is co-sponsored by the following:

·         Sen Daniel Akaka, D-Hawaii

·         Sen Mark Begich, D-Alaska

·         Sen Richard Blumenthal, D-Conn.

·         Sen Tom Harkin, D-Iowa

·         Sen Patrick Leahy, D-Vt.

·         Sen Bernie Sanders, I-Vt.

·         Sen Chuck Schumer, D-N.Y.

It is very doubtful that this bill is going anywhere.

Here is another proposal. We can call it the Biden Rule:

         Politicians who stay in Washington more than 10 years pay a 100% tax rate.

Thinking on This Week's Senate Surtax

The Senate Democrats have offered yet another tax to pay for yet another $447 billion stimulus package. They now want to impose a 5.6% surtax on income over $1 million per couple.

Let’s add-up the increases that are being discussed or have already been passed into legislation:

·         The expiration of the Bush tax cuts                          39.6%

·         The phase-out of itemized deductions (Pease)        1.19%

·         The phase-out of personal exemptions (PEP)           1.15%

·         The Medicare surtax on investment income            3.8%

·         The Medicare surtax on earned income                    0.9%                   

·         This week’s Senate Democrat proposal                    5.6%

                                                                                              --------------            

                                                                                                                       52.24%                                                                          

I doubt this list is complete as the above is just off the top of my head. 

You get the idea.

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.