Basis step-up on assets inherited from nonresident

Yes, I’m back from more than a week off the grid in the Quetico Provincial Park, paddling and portaging. This was a Boy Scout trip with my son’s troop, starting from the Charles L. Sommers Wilderness Canoe Base. Who knew that going canoeing involves carrying extremely heavy stuff over steep, treacherous portages in the rain? I’ve already signed up for next year’s trip–a 12 day high country backpacking extravaganza at Philmont.

People keep asking me, uh, where’s your brother? (YouTube, turn it up loud).

No, actually, people keep asking me about whether they get a step up in basis for foreign assets inherited from a nonresident/noncitizen decedent.

Or, to say it in English, “My dad died and left me a piece of real estate in the old country. I’m going to sell it. What happens for U.S. tax purposes when I sell it?”

Ignore the tax imposed in the country where the real estate is located. Pretend there is no tax imposed. All we care about is capital gain tax for the U.S. heir who sells the property.

The capital gain must be reported on the U.S. heir’s personal Form 1040 in the year of sale. So the question is how do we calculate that capital gain? The answer — sale price minus expenses of sale minus the seller’s basis in the property equals capital gain for U.S. tax purposes.

The sale price is whatever it is. Expenses of sale are whatever they are. But basis. A U.S. taxpayer who inherits foreign real estate from a nonresident/noncitizen of the USA — this is interesting. The real estate was never subjected to U.S. estate tax. The deceased person never filed a U.S. income tax return, and the executor never filed a U.S. estate tax return, because they didn’t have to.

Does an asset inherited from a nonresident/noncitizen get a step up in basis even though no estate tax was ever imposed?

Yes, indeed.

Back to our little example. Pretend that Dad bought the land in the old country for $10,000 way back when. At the time of death the land was worth $100,000. The U.S. son who inherited the property immediately sold it for $100,000. Pretend that sale expenses are zero, because that makes my example a bit easier.

The U.S. son reports the sale on Schedule D. Proceeds of sale of $100,000 minus basis of $100,000 equals capital gain of zero.

For your light reading, here is Rev. Rul. 84-139, 1984 C.B. 168, which describes the situation and the reason why we get the results that we do.  Study hard.  There is a quiz at the end of the period.

REV. RUL. 84-139, 1984-2 C.B. 168

ISSUE

Will a United States citizen who inherits foreign real property from a nonresident alien receive a stepped-up basis in such property under section 1014 of the Internal Revenue Code even though the property is not includible in the value of the decedent’s gross estate?

FACTS

D, who was a citizen and a resident of Z, a foreign country, died in 1982 owning real property located in Z. B, a United States citizen, inherited the real property in accordance with the laws of Z. At the time of D’s death, the real property had a basis of 100 x dollars and a fair market value of 1000x dollars. Because the real property is located outside the United States and D was a nonresident alien, the value of such property is not includible in D’s gross estate under section 2103 of the Code for purposes of the United States federal estate tax. B sold the real property in 1983 for 1050x dollars, claiming a basis of 1000x and a gain of 50x dollars.

LAW AND ANALYSIS

Section 1014(a)(1) of the Code states that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be the fair market value of the property at the date of the decedent’s death.

Section 1014(b)(1) of the Code provides that property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent shall be considered to have been acquired from or to have passed from the decedent for purposes of section 1014(a).

Section 1014(b)(9)(C) of the Code further provides that section 1014(b)(9) shall not apply to property described in other paragraphs of section 1014(b).

Section 1014(b)(9) of the Code provides that, in the case of a decedent dying after December 31, 1953, property acquired from a decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of a decedent’s gross estate shall be considered to have been acquired from or to have passed from the decedent for purposes of section 1014(a).

Section 1.1014-2(b)(2) of the Income Tax Regulations provides that section 1014(b)(9) property does not include property that is not includible in the value of a decedent’s gross estate, such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States.

In this case, B inherited the real property from D, and such property is within the description of property acquired from a decedent under section 1014(b)(1) of the Code. Therefore, B will be entitled to a stepped-up basis under section 1014(a). Under section 1014(b)(9)(c), section 1014(b)(9) does not apply to property described in section 1014(b)(1); hence, the requirement of section 1014(b)(9) that property be includible in the value of a decedent’s gross estate does not apply here.

HOLDING

Foreign real property that is inherited by a United States citizen from a nonresident alien will receive a step-up in basis under sections 1014(a)(1) and 1014(b)(1) of the Code. B’s basis in the real property sold is 1000x, the fair market value of the property on the date of D’s death, as determined under sections 1014(a)(1) and 1014(b)(1) of the Code.

Property you acquired before coming to the USA

This is a quick little blog post to answer a recurring question for many people out there.  It came up in the course of some work I am doing right now.

Situation

You are a nonresident of the United States.  Thirty years ago you bought a piece of land in your home country for US$10,000.  Now it is worth US$200,000.

You immigrate to the United States, then sell the land for its current value — US$200,000.

Question

Do you pay U.S. capital gain tax on the entire $190,000 of capital gain?

Answer

Yes.

Why

Just because you change status from nonresident to resident of the United States, you don’t change the U.S. tax laws that apply to your transaction.  Unfortunate but true.  You calculate your U.S. tax results using U.S. tax law, despite the fact that you were a nonresident when you bought the property.

From 1998 FSA LEXIS 402:

In several cases, the Tax Court has determined the adjusted basis of property acquired by a U.S. taxpayer outside the U.S. before becoming a U.S. resident. The court has assumed as the starting point the taxpayer’s appropriate basis under U.S. tax principles. Compare Gutwirth v. Comm’r, 40 T.C. 666 (1963) (1939 Code) and Benichou v. Comm’r, T.C. Memo 1970-263 (taxpayer’s basis was initial cost) with Reisner v. Comm’r, 34 T.C. 1122 (1960) (taxpayer’s basis was fair market value upon inheritance). In general, the taxpayer’s cost basis for purchased property has been determined to be the initial expenditure in the foreign jurisdiction.n5 See Heckett v. Comm’r, 8 T.C. 841 (1947).

The same idea is true if you acquired the property by inheritance.  Your acquisition basis (and therefore the starting point for calculating capital gain) is the date of death value for property.  (Date of death = the date the person from whom you inherited the property died).

But I digress . . .

The Reisner v. Commissioner case contains an interesting little tidbit of information for those of you handling World War II restitution cases.  (Yes, I still run into this every so often, most recently in an OVDI case).  There a gentleman was forced to sell property in Berlin in 1937.   He had inherited the property in 1926 from his parents.  After the war he recovered the property under an order of restitution — Order No. 49 by the Allied Berlin Kommandatura.  The legal effect of this order told the Tax Court everything it needed to know about calculating the basis of the buildings in the hands of the taxpayer.

The order said that anyone receiving restitution under the order would be treated as if he had an unbroken chain of title — that the property had always been his.

This gave the Tax Court an easy way to determine the basis of the buildings in the hands of the taxpayer — date of death valuation in 1926 plus the cost of capital improvements.

It is rare that you find a non-tax fact so clear as that postwar order.  Usually these World War II restitution cases are messy in the extreme.

I’m back now

And the results of this case give us clear guidance on how you should handle your capital gain tax for the year of sale.  This gentleman was deemed to have acquired the property by inheritance while a nonresident of the United States.  He got the 1926 acquisition cost (calculated under U.S. tax law).

Exception for exit tax

There is a weird little exception for people who expatriate.  Green card holders.  I will write a blog post about this later.  If you come to the United States, stay long enough with a green card, then leave the country and are subjected to the exit tax (Section 877A; go see Form 8854), you can use the “date of entry” value to calculate your capital gain for purpose of the mark-to-market gain.

All gibberish for those of you who don’t live inside the Holy Temple of Exit Tax, I’m sure.  Here’s an example.

You are a nonresident of the United States.  Thirty years ago you bought a piece of land in your home country for US$10,000.  Now it is worth US$200,000.

You immigrate to the United States, stay for 10 years, and then say “Oh, (blankety blank blank).  I’m outta here!” and relinquish your green card.  You still have the land.  At that point it is worth $300,000.

For exit tax purposes (assuming you are a “covered expatriate”) you are deemed to have sold the land at fair market value on the day before you gave up your green card.  So you’re treated as selling at $300,000.  Lucky for you, though, you get to use the value of the property on the day you came into the USA — $200,000 — to calculate that exit tax.  So you only pay tax on $100,000 of capital gain.  Make-pretend capital gain.  Lucky you.

Yeah

We need more unnecessary complexity.  Please Congress — write more ill-conceived tax laws charmingly devoid of common sense and jet-fueled by partisan lobbyists and Poli Sci majors burnishing their resumes with three years of work on the Hill, all with an ideological ax to grind and a pocket to stuff with government largesse.  (Who by the way couldn’t spell “If A, then B” if you handed them both letters).  (Both parties offend me; spare me your tortured outrage.  I’ve received too many emails saying “How COULD you??? Are you one of THEM?????” emails).  (But I’m not bitter.)

Sigh.

List of U.S. estate tax treaties

For the people in my San Francisco CalCPA course yesterday. . . here is the list of estate and gift tax treaties from the IRS website.

Estate tax sunset in 2010 applies to nonresidents

I received an email inquiry from a CPA friend about this, so I thought I would share it generally.

Question

Does the 2010 repeal of the estate tax apply to nonresidents of the United States?

Answer

Yes.  The repeal applies to residents and nonresidents alike.

Background

The estate tax disappeared on December 31, 2009.  It is designed to re-appear on January 1, 2011.  Tag that:  #politicalgames

The Tax Geek’s explanation

Section 2210(a) of the Internal Revenue Code says:

“Except as provided in subsection (b), this chapter shall not apply to estates of decedents dying after December 31, 2009.”

“This chapter” means Internal Revenue Code, Subtitle B, Chapter 11, which contains Sections 2001 through 2210.  These are the estate tax rules.  Thus, the estate tax rules are universally not applied to decedents dying after December 31, 2009.

The estate tax as it applies to nonresidents is described in Sections 2101 through 2108 of the Internal Revenue Code.  These sections are within Chapter 11.  The same Chapter 11 that does not apply to people dying after December 31, 2009.

Therefore, nonresidents are not subjected to U.S. estate taxation if they die after December 31, 2009.

Reinstatement of estate tax in 2011

The estate tax comes back in 2011, for residents and nonresidents alike.  Here’s the magic language, which is from Section 901 (Sunset of Provisions of Act) of Pub. L. 107-16, as amended by Pub. L. 107-358:

(a) IN GENERAL.–All provisions of, and amendments made by, this Act shall not apply–

(1) to taxable, plan, or limitation years beginning after December 31, 2010, or

(2) in the case of title V, to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010.

(b) APPLICATION OF CERTAIN LAWS.–The Internal Revenue Code of 1986 and the Employee Retirement Income Security Act of 1974 shall be applied and administered to years, estates, gifts, and transfers described in subsection (a) as if the provisions and amendments described in subsection (a) had never been enacted.

(c) EXCEPTION.-Subsection (a) shall not apply to section 803 (relating to no federal income tax on restitution received by victims of the Nazi regime or their heirs or estates).

Reinstatement means 2001 rules apply

For your purposes, Section 901(a)(1) is what matters. The “Act” (which is what put the estate tax on ice for 2010) does not apply at all after December 31, 2010. That means you look at the law as if the “Act” never existed. And that, in turn, means that you look at estate tax law as it existed in 2001 to see what the tax rules will be.

Trust me. The estate tax rules apply to nonresidents in 2011.

Why nonresident decedents get step-up basis at death

For some of you this post is going to be a bit of inside baseball. Sorry.

If you’re not a tax propellerhead person, here’s the bottom line: your parents live outside the United States, you inherit foreign real estate from them? You inherit the real estate without estate tax, and when you sell the U. S. capital gain tax is calculated at the difference between the price you sell it for and the value when your parents died.

Explanation of basis step-up rule for nonresident-noncitizens

This is for the people who attended my Foreign Trusts course on 14 January 2010 and my FIRPTA course on 15 January 2010 — live in person, or on the webcast. I promised a series of follow-ups to questions raised in the class. Here’s the first of the answers.

The question is step-up in basis for assets owned by a nonresident-noncitizen of the United States. It seems counterintuitive that an asset which is not subject to U.S. estate tax will get stepped up basis. Yet that’s how it works.

Here’s Revenue Ruling 84-139, which neatly answers the question.

Revenue Ruling 84-139

Rev. Rul. 84-139; 1984-2 C.B. 168; 1984 IRB LEXIS 141

SUBJECT MATTER: Section 1014.-Basis of Property Acquired from a Decedent

APPLICABLE SECTIONS:
26 CFR 1.1014-1: Basis of property acquired from a decedent.

TEXT:

Basis; property acquired from nonresident alien decedent. Foreign real property that is inherited by a United States citizen from a nonresident alien will receive a step-up in basis under section 1014 of the Code even though the property is not includible in the value of the decedent’s gross estate.

ISSUE

Will a United States citizen who inherits foreign real property from a nonresident alien receive a stepped-up basis in such property under section 1014 of the Internal Revenue Code even though the property is not includible in the value of the decedent’s gross estate?

FACTS

D, who was a citizen and a resident of Z, a foreign country, died in 1982 owning real property located in Z. B, a United States citizen, inherited the real property in accordance with the laws of Z. At the time of D’s death, the real property had a basis of 100x dollars and a fair market value of 1000x dollars. Because the real property is located outside the United States and D was a nonresident alien, the value of such property is not includible in D’s gross estate under section 2103 of the Code for purposes of the United States federal estate tax. B sold the real property in 1983 for 1050x dollars, claiming a basis of 1000x and a gain of 50x dollars.

LAW AND ANALYSIS

Section 1014(a)(1) of the Code states that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be the fair market value of the property at the date of the decedent’s death.

Section 1014(b)(1) of the Code provides that property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent shall be considered to have been acquired from or to have passed from the decedent for purposes of section 1014(a).

Section 1014(b)(9) of the Code provides that, in the case of a decedent dying after December 31, 1953, property acquired from a decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of a decedent’s gross estate shall be considered to have been acquired from or to have passed from the decedent for purposes of section 1014(a).

Section 1014(b)(9)(C) of the Code further provides that section 1014(b)(9) shall not apply to property described in other paragraphs of section 1014(b).

Section 1.1014-2 (b)(2) of the Income Tax Regulations provides that section 1014(b)(9) property does not include property that is not includible in the value of a decedent’s gross estate, such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States.

In this case, B inherited the real property from D, and such property is within the description of property acquired from a decedent, under section 1014(b)(1) of the Code. Therefore, B will be entitled to a stepped-up basis under section 1014(a). Under section 1014(b)(9)(c), section 1014(b)(9) does not apply to property described in section 1014(b)(1); hence, the requirement of section 1014(b)(9) that property be includible in the value of a decedent’s gross estate does not apply here.

HOLDING

Foreign real property that is inherited by a United States citizen from a nonresident alien will receive a step-up in basis under sections 1014(a)(1) and 1014(b)(1) of the Code.

B’s basis in the real property sold is 1000x, the fair market value of the property on the date of D’s death, as determined under sections 1014(a)(1) and 1014(b)(1) of the Code.