Basis Step Up for Foreign Assets – How and Why It Works

May 24, 2024 in Trusts

Basis Step Up for Foreign Assets – How and Why It Works

This newsletter is about stepped-up basis for foreign assets inherited by a U.S. taxpayer from a deceased non-U.S. person. Foreign asset, foreign owner who dies, the U.S. tax system never touches the asset – still you can get basis step-up for that asset.

The question

Simplified fact pattern.

Nonresident-noncitizen Parent is a citizen of and owns real estate in $Country. Child is a U.S. citizen. Parent dies, and Parent’s will says “transfer all my assets at death to my child.”

Child inherits the foreign real estate.

Does Child get a date-of-death value for his basis in the foreign real estate?

(Note: my problem was an esoteric version of the simplified facts. But I always start my analysis with a stripped-down version of the facts, then add one complexity at a time and analyze it until I have my actual fact pattern.)

What’s the answer?

If your answer is “Yes,” you are right. Do you know why you’re right?

I thought I knew why “Yes” was the correct answer. My reason for believing my own brain was wrong, but there was another reason why “Yes” was, indeed, the right answer.

Date-of-death value is your basis when . . .

Section 1014(a)(1) is the rule that awards basis step-up when property is acquired from a deceased person.

Except as otherwise provided in this section, 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 (1) the fair market value of the property at the date of the decedent’s death[.]

Note: it is the method of transfer that matters. Inclusion of the asset in the decedent’s gross estate is not mentioned or required.

Simplified, Section 1014(a)(1) says:

  • IF you (acquire property from a decedent OR property passed to you from a decedent)
  • THEN basis for the property is fair market value on the decedent’s date of death.

The meaning of “you acquire property from a decedent”

The definition of “person acquiring the property from a decedent or to whom the property passed from a decedent” is hardwired for you at Section 1014(b). No thought required.

There are seven different ways to be a “person acquiring the property from a decedent or to whom the property passed from a decedent”. If your transfer is described in one of those seven ways, the property you receive gets a date-of-death valuation as its basis.

Let’s look at a couple of them.

An asset untouched by U.S. tax law can get basis step-up

Let’s look at Rev. Rule. 84-139, which answered “Yes” to the following question by applying IRC Section 1014(b)(1):

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?

Yes, said the Revenue Ruling. Why? Here’s the bullet-point analysis:

  • You get basis step-up if you acquire property from a decedent. Section 1014(a)(1).
  • You acquire property from a decedent if it is acquired by “bequest, devise, or inheritance” from the decedent. Section 1014(b)(1).
  • The normal process of inheriting property because the deceased person’s will gives it to you is a “bequest.”
  • Therefore, if you acquire the property from the deceased person because that’s what the will says, you get basis step-up to the date-of-death value.

Another way to get basis step-up

So, a bequest is one way to qualify for basis step-up.

Inclusion of an asset in a decedent’s gross estate is another way for basis step-up to occur for that asset. Section 1014(b)(9).

[P]roperty 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 under chapter 11 of subtitle B . . . .. In such case, if the property is acquired before the death of the decedent, the basis shall be the amount determined under subsection (a) reduced by the amount allowed to the taxpayer as deductions in computing taxable income under this subtitle or prior income tax laws for exhaustion, wear and tear, obsolescence, amortization, and depletion on such property before the death of the decedent. Such basis shall be applicable to the property commencing on the death of the decedent. This paragraph shall not apply to . . . (C) property described in any other paragraph of this subsection.

Tie-breaker rule

It is easy for a transfer to qualify for step-up in basis by being an “acquire property from a decedent” under both Section 1014(b)(1) (the right type of transfer) and Section 1014(b)(9) (inclusion in the gross estate).

If you own real estate and you die, the property transfers by operation of the will – a bequest under IRC Section 1014(b)(1). Also, the decedent owned the asset, so the asset would be included in the decedent’s gross estate.

Section 1014(b)(9) therefore contains a tie-breaker rule. If Section 1014(b)(9) and any other paragraph in Section 1014(b) would apply, then ignore Section 1014(b)(9) and apply the other paragraph to authorize a step-up in basis. IRC Section 1014(b)(9)(C).

In my little example (taken from Rev. Rul. 84-139) both rules work, and because of that, we are ordered to drop Section 1014(b)(9) and apply Section 1014(b)(1).

Why gross estate inclusion doesn’t work for foreign assets

Section 1014(b)(9) gives basis step-up if the property transferred (in almost any conceivable method) from a decedent is included in the gross estate.

“Gross estate” as we usually think about it is defined at Section 2033: all interests in property everywhere owned by the decedent at the time of death. But for a nonresident-noncitizen decedent? The gross estate includes U.S. situs assets only. IRC Section 2103.

  • For the purpose of the tax imposed by section 2101, the value of the gross estate of every decedent nonresident not a citizen of the United States shall be that part of his gross estate (determined as provided in section 2031) which at the time of his death is situated in the United States.

In the example, foreign Parent’s gross estate – as defined by Section 2103 – did not include real estate situated outside the United States. Therefore, Section 1014(b)(9)’s allowance of basis step-up cannot apply to the foreign real estate because (tah dah) the critical element triggering basis step-up — gross estate inclusion — doesn’t occur.

Reg. Section 1.1014-2(b)(2) says this out loud:

(This paragraph) does not include property 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.

As a result, we can state a general rule that foreign assets will never get basis step-up because of the rule at IRC Section 1014(b)(9) – because of inclusion in the decedent’s gross estate. Foreign assets simply are never included in the decedent’s gross estate, therefore Section 1014(b)(9) doesn’t work at all. No inclusion, no Section 1014(b)(9).

More complicated: transfers through trusts

Let’s take this simple example (and I recommend reading Rev. Rul. 84-139 to reinforce the ideas) and make it complicated.

How can you get basis step-up for trust assets? Well, a retained interest in the trust assets will work.

And (handwavy assumption based on dim memories) that makes an inclusion in the gross estate of the decedent, and that triggers basis step-up for the trust assets. The trust can then distribute the property to the U.S. beneficiary with basis step-up.

Wrongo.

Sometimes foreign assets in foreign trusts will get a basis step-up. Sometimes they won’t. It depends on how you read the trust.

Retained power to revoke trust

You “acquire property from a decedent” (thereby qualifying for basis step-up for trust assets) if the trust is revocable. IRC Section 1014(b)(2).

For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (2) Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his death to revoke the trust;

Power to revoke is a retained interest, so causes gross estate inclusion for the trust assets. But the tie-breaker rule says that because IRC Section 1014(b)(2) and IRC Section 1014(b)(9) both apply, we apply IRC Section 1014(b)(2) and ignore IRC Section 1014(b)(9).

Retained power over enjoyment of income

You “acquire property from a decedent” (thereby qualifying for basis step-up for trust assets) if the decedent controls the enjoyment of income. IRC Section 1014(b)(3).

For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (3) In the case of decedents dying after December 31, 1951, property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent with the right reserved to the decedent at all times before his death to make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust;

Power to change the beneficiaries’ enjoyment of trust income is a retained interest, so causes gross estate inclusion for the trust assets. But the tie-breaker rule says that because IRC Section 1014(b)(2) and IRC Section 1014(b)(9) both apply, we apply IRC Section 1014(b)(2) and ignore IRC Section 1014(b)(9).

Other retained interests

But! You do not “acquire FOREIGN property from a decedent” merely because a retained interest causes gross estate inclusion. IRC Section 1014(b)(9). You must find a specific rule in IRC Section 1014(b)(1) – (8) that applies.

For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent: (9) In the case of decedents 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 under chapter 11 of subtitle B or under the Internal Revenue Code of 1939. . . .

The retained interest will drag U.S. situs trust assets into the gross estate (exposing them to estate tax and giving the transferee a basis step-up). The retained interest will not drag foreign situs assets into the gross estate. These are excluded from the gross estate by IRC Section 2103 and denied basis step-up treatment by Reg. Section 1.1014-2(b)(2).

Takeaways

Here are my takeaways and suggestions:

  • Read Rev. Rul. 84-139 for a simple example of how basis step-up works with a foreign decedent, foreign assets, and a U.S. beneficiary.
  • Have a checklist for analysis of complex topics. (I have one for foreign trusts. This saved my butt. The sad part was that the butt-saving step was right at the end of a full day of work that I wrote off.)
  • Just because I knew this stuff (having read Rev. Rul. 84-139 many times and remembering its result in a handwavy way), doesn’t mean that I knew it, IYKWIM.
  • If you’re dealing with foreign trusts, it’s common to find retained interests. These do not create gross estate inclusion for foreign assets held in trusts, so IRC Section 1014(b)(9) does not apply. You must apply either IRC Section 1014(b)(2) or (3) to get the basis step-up.
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