[NOTE: this post originally appeared on The Vanilla Shell on December 31, 2010]
On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Act”) into law. Much has been written about the Act, particularly in regards to the extension of the 2001 income tax rate reductions, the changes to the estate tax and, of course, the politics of what’s “fair.”
Lost in the shuffle are some very significant provisions contained in the Act for real estate owners. For instance, the 15 year cost recovery period (as opposed to 39 years under pre-2001 law) for leasehold improvements was renewed for improvements made between January 1, 2010 and December 31, 2011. Additionally, the 50% bonus depreciation for capital investment has been increased to 100% for assets placed in service between September 8, 2010 and January 1, 2012. Other provisions extended in the legislation of importance to the real estate industry include renewal of several energy-efficient tax credits, expensing for brownfield cleanup activities and a deduction for mortgage insurance premiums (capped at individuals with less than $100,000).
Perhaps the most important piece of the legislation for real estate owners lies in the changes to the Federal estate tax. While it is true that there has been no Federal estate tax in 2010, the downside to this has been that a modified carryover basis structure has taken its place. This has created numerous headaches particularly for estates consisting of significant real estate holdings.
The “basis” of a piece of property is generally the purchase price of that property and is used to calculate taxable gain when property is sold. The greater the increase in value of property, the greater the taxable gain when sold. A “step-up in basis” means that the basis of inherited property increases to the value of the property on the date of death.
For the year 2010 and prior to the recent legislation, “step-up” was replaced by “carry-over basis” rules. Carry-over basis generally means the basis of inherited property remains the same as it was for the deceased owner; which potentially increases the amount of gain (and tax) when the property is sold. When property is inherited, the heir can choose to take a “step-up” in basis for only $1.3 million of the property. For any amount inherited over $1.3 million, the heir’s basis will be the smaller of the deceased owner’s basis or the date-of-death-market value. The basis of property passing to a surviving spouse can be increased by an additional $3 million.
One of the most powerful aspects of the 2010 Act is a provision which allows estates where the decedent died in 2010 to retroactively elect to be subject to the Federal estate tax. For most estates, this will still mean a zero tax result (since the new Federal estate tax exemption amount is $5.0 million) but these estates can then receive a step-up in basis rather than the carryover basis rules in place prior to the new law. Making this election could result in a significant tax savings later on whenever the heirs decide to sell the property.
There are other aspects of the Act related to the Federal estate tax that could impact real estate owners as well (the new portability provisions, for example). The reinstatement of stepped-up basis, however, might prove to be the most significant tax-savings provision when it comes to real estate.