Step up in basis for nonresident’s assets in irrevocable trust
What “basis” is
One of the continuing mysteries of life involves the concept of “basis”. Think of basis as your acquisition cost. This is essential in calculating your capital gain tax after selling an asset. Capital gain is the difference between the sale price and your acquisition cost. The higher your basis — or acquisition cost — for an asset, the lower your capital gain (and therefore capital gain tax) will be.
Here is an example:
A person bought a piece of land 20 years ago for $100,000, and now it is worth $1,000,000. If that person sells the real estate today, the capital gain would be $900,000 ($1,000,000 received from sale minus $100,000 acquisition cost). Multiply the $900,000 capital gain by the correct tax rate and you have the tax that must be paid in the year of sale.
Basis when you inherit an asset
It is easy to understand “acquisition cost” when you buy something: how much money did it cost? But what about when you inherit something?
In that case, your acquisition cost (or “basis”) is the fair market value of the asset when the previous owner died. (In some instances you can use the value on the date 6 months after the person died). Think of this as if you “bought” the asset at fair market value on the date of death of the person who left you the inheritance.
Again, an example:
A person bought a piece of land 20 years ago for $100,000, and it is worth $1,000,000 when he dies. The person leaves the land to you in his will. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
These basis rules are found in Internal Revenue Code Section 1014.
Step up in basis
Wait. There’s a disconnect: $900,000 of taxable capital gain evaporated. You got a fresh start, so if you sell the land for $1,000,000 you will pay zero capital gains tax — because you have zero capital gain. The land is worth $1,000,000 and your acquisition cost (“basis”) is $1,000,000. Yet, if the person who left you the land had sold it a month before he died, there would have been $900,000 of capital gain, and capital gain tax would be imposed. What happened?
The “what happened” is a concept called “step up”. Simply put, if someone owns an asset when he dies, all of the built-in capital gain is eliminated. The deceased person’s basis (acquisition cost) in the asset adjusted upward to the fair market value when he died. This upward adjustment is called “step up” in tax jargon.
The reverse can happen, of course. The adjustment goes to market value on the date of death. Market value can be lower than acquisition cost. It’s been known to happen once or twice.
Inheriting from a nonresident
The same concepts apply when a U.S. taxpayer inherits an asset from a nonresident.
A resident of Saudi Arabia bought a piece of land in Jeddah 20 years ago for $100,000, and it is worth $1,000,000 when he dies. You inherit the land. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
The first time I wrestled with this idea, I was boggled. Here was a tax break (the step up in basis) extended by the U.S. government to an asset outside the United States — an asset that had never been subjected to U.S. estate tax. It made sense, I thought, that the step up in basis idea would apply to an asset that passed through the U.S. estate tax gauntlet. If you inherit something and Uncle Sam had the chance to tax it (by imposing a tax on the estate of the deceased person), fairness says you get the new “acquisition cost” or basis in the asset you inherit.
Yet we have the interesting situation that a piece of land outside the United States is now owned by a U.S. person with an acquisition cost equal to the value of the property on the date of death.
Inheriting through a trust from a nonresident
Now we get to the point of this blog post. For a variety of reasons, people use trusts to hold their assets and pass the assets to their heirs. It’s usually simpler than the local Probate Court proceedings, and it gives far greater privacy. Probate is usually a publicly visible process. Trusts can be opaque to the outside world. Trusts are also a useful tool if you want to have outside managers for your assets.
But assets put into a trust are no longer passed to the heirs at death as an inheritance. The “heirs” are beneficiaries of the trust. What they receive (and when they receive it) is governed by what the trust document says.
This means that you cannot rely on the classic “step up in basis” rules I have described above. If an asset is distributed to a beneficiary from a trust, it will have the same acquisition cost (“basis”) as the trust had in the asset. The tax law jargon for this is “carryover basis”.
But that’s not universally true. It is possible for a nonresident to put assets into a trust (thereby avoiding the local probate procedures) and at the same time get step up in basis for the trust beneficiary (the heir) who receives the assets when the nonresident dies. All of this can happen while there is no U.S. estate tax imposed on the assets.
A resident of Hong Kong creates the right kind of trust (I will describe what “right kind of trust” means in a minute). He bought land in Hong Kong 40 years ago for US$100,000, and now it is worth US$1,000,000. He transfers the land in to the trust. A U.S. individual is the beneficiary of the trust. When the Hong Kong resident dies, the terms of the trust instruct the trustee to distribute the land to the beneficiary.
The beneficiary will receive the land from the trust with a stepped up basis of $1,000,000. If the beneficiary immediately sells the land at its fair market value of $1,000,000, he will have zero capital gain because his acquisition cost (basis) is US$1,000,000 and the money received from the sale is US$1,000,000.
Best of both worlds, etc. There is no U.S. estate tax (and no Hong Kong estate tax, for that matter). And there is no U.S. capital gain tax.
What kind of trust will work? A “grantor” trust
So what kind of trust should a nonresident of the United States establish in order to leave assets to a U.S. person at the time of the nonresident’s death? Simple: a “grantor” trust. This is a trust that — according to U.S. tax law — is treated as if the settlor (the person who contributed the assets to the trust) is the owner of all of the trust assets.
The grantor trust rules are in Internal Revenue Code Sections 671 through 679.
There are two kinds of grantor trusts that will work for nonresidents of the United States:
- Revocable. The idea here is that if the settlor can unilaterally take the assets out of the trust at any time, the situation is functionally identical to direct ownership of the assets by the settlor. The assets remain in the trust solely at the settlor’s whim.
- Irrevocable. With an irrevocable trust, the settlor does not have the unilateral power to extract assets from the trust anytime he wants to. But an irrevocable trust can be a grantor trust if the settlor (or settlor plus spouse) is the sole beneficiary during the lifetime of the settlor (or spouse).
A grantor trust can be a “foreign” grantor trust or a domestic grantor trust. We usually refer to domestic grantor trusts as simply being a grantor trust. A “foreign” trust of any type, whether grantor or nongrantor, is a trust that is either governed by a court outside the United States or is controlled (even just a little bit) by someone who is not a U.S. resident or citizen. I will leave the discussion of whether to make your grantor trust “foreign” or domestic for another blog post.
Private Letter Ruling 201245006 – An Irrevocable Trust is Approved
Don’t take my word for it. Read Private Letter Ruling 201245006. Specifically, look at Issue 1, where the use of an irrevocable trust (properly configured to be a grantor trust) was approved. Private Letter Rulings are only applicable to the taxpayer receiving the ruling, yadda yadda.
Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Release Date: 11/9/2012
Index Number: 671.00-00, 1014.00-00
Person To Contact:
Refer Reply To: CC:PSI:B04 _PLR-105239-12
Date: JULY 19, 2012
Company 1 =
Company 2 =
Dear [redacted data]:
This letter responds to your authorized representative’s letter, dated February 2, 2012, requesting a ruling on the application of § 671 and § 1014 of the Internal Revenue Code.
The facts submitted and representations made are as follows:
Taxpayer, a citizen and resident of Country, proposes to transfer assets to Trust, an irrevocable trust subject to the laws of Country. The assets of Trust include cash and stock in Company 1 and Company 2 that are publicly traded in Country and on the New York Stock Exchange. Taxpayer and X, an unrelated party, are Trustees.
Under the terms of Trust, Trustees are to pay all of the income of Trust to Taxpayer during his lifetime and may, in Trustees’ absolute discretion, pay principal of Trust to Taxpayer. Article IV. Upon the death of Taxpayer, any income of Trust and any corpus remaining in Trust are to be paid or transferred to or in trust for one or more of Taxpayer’s issue in such proportions as Taxpayer may appoint by deed or will. In default of appointment, corpus and accumulated income will be held in further trust for the benefit of Taxpayer’s issue. Article V. Trust further provides that during Taxpayer’s lifetime no adverse party within the meaning of § 672(a) is eligible to serve as Trustee. Article XI.
You have requested the following rulings:
1. Following the death of Taxpayer, the basis of the property held in Trust at Taxpayer’s death will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
2. Taxpayer will be treated as the owner of Trust for purposes of § 671, such that the items of income, deductions and credits against tax of Trust will be included in computing Grantor’s taxable income and credits against tax.
Section 1014(a)(1) provides 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) 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 § 1014(a).
Section 1014(b)(9) provides that, in the case of a decedent dying after December 31, 1953, property acquired from the 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 the decedent’s gross estate, shall be considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a).
Section 1014(b)(9)(C) provides that § 1014(b)(9) shall not apply to property described in any other paragraph of § 1014(b).
Section 1.1014-2(b)(2) of the Income Tax Regulations provides, in part, that § 1014(b)(9) property does not include property that is not includible in the 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, Taxpayer’s issue will acquire, by bequest, devise, or inheritance, assets from Trust at Taxpayer’s death. The assets acquired from Trust are within the description of property acquired from a decedent under § 1014(b)(1). Therefore, Trust will receive a step-up in basis in Trust assets under § 1014(a) determined by the fair market value of the property on the date of Taxpayer’s death. See Rev. Rul. 84-139, 1984-2 C.B. 168 (holding that foreign real property that is inherited by a U.S. citizen from a nonresident alien will receive a step-up in basis under § 1014(a)(1) and 1014(b)(1)). This rule applies to property located outside the United States, as well as to property located inside the United States.
Accordingly, based solely upon the information submitted and the representations made, we conclude that following the death of Taxpayer, the basis of the property held in Trust will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
Section 671 provides, in part, that where it is specified in subpart E of subchapter J that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.
Section 672(f)(1) and § 1.672(f)-1 provide that, as a general rule, the grantor trust rules (§ § 671 through 679) apply only to the extent such application results in an amount (if any) being taken into account (directly or through one or more entities) in computing the income of a citizen or resident of the United States or a domestic corporation. Section 672(f)(2)(A)(ii) and § 1.672(f)-3(b)(1) provide that the general rule does not apply to any portion of a trust if the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.
Section 677(a)(1) provides that the grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under § 674, whose income without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be distributed to the grantor or the grantor’s spouse.
Under the terms of Trust, the trustees are required to pay all Trust income to Taxpayer during his lifetime and the trustees are authorized to pay, in their absolute discretion, any amounts out of the capital of Trust to Taxpayer. In addition, the only distributions that Trust may make during the Taxpayer’s lifetime are to Taxpayer. Thus, § 672(f) will not prevent Taxpayer from being treated as the owner of Trust. Therefore, Taxpayer will be treated as the owner of Trust under § 677(a).
The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.
Except as specifically ruled herein, we express no opinion on the federal tax consequences of the proposed transaction under the cited provisions or under any other provisions of the Code.
This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.
Leslie H. Finlow
Senior Technician Reviewer, Branch 4
Office of Associate Chief Counsel
(Passthroughs and Special Industries)
Copy for section 6110 purposes
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?
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
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?
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.
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.
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.
Do you pay U.S. capital gain tax on the entire $190,000 of capital gain?
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.
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.)
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.
Does the 2010 repeal of the estate tax apply to nonresidents of the United States?
Yes. The repeal applies to residents and nonresidents alike.
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.