Step-Up Basis Law: Applicability To Nonresident Aliens

The step-up basis rule, as per Section 1014 of the Internal Revenue Code, allows for a reset of the cost basis of an inherited asset to its fair market value on the date of the benefactor's death. This rule applies to US citizens inheriting foreign real estate from nonresident aliens, as outlined in Rev. Rul. 84-139. The step-up basis rule can result in significant tax savings for beneficiaries, but it does not apply to all assets, including those held in retirement accounts or most irrevocable trusts.

Foreign real property inherited by a US citizen from a nonresident alien

For example, let's say a US citizen inherits a property in a foreign country from a nonresident alien. The nonresident alien originally purchased the property for $100,000, and at the time of their death, the property was worth $250,000. The US citizen would get a step-up in basis, so the cost basis of the property would be $250,000 instead of $100,000. If the US citizen then sold the property for $300,000, they would only pay capital gains tax on the difference between $250,000 and $300,000, instead of the difference between $100,000 and $300,000.

It is important to note that the step-up in basis only applies to inherited property, not to property received as a gift. Additionally, the US citizen must report the foreign inheritance to the IRS on Form 3520, "Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts." This form is used to report any gifts or inheritances received by a US person from a foreign person that exceed $100,000 in a calendar year. The form must be filed in the year the inheritance was received to avoid potential penalties from the IRS.

Furthermore, local country tax laws may also apply to the inheritance, and the property may be subject to other taxation in the local jurisdiction. The US citizen should be aware of any tax obligations in the country where the property is located and ensure compliance with the tax laws of both countries.

In conclusion, foreign real property inherited by a US citizen from a nonresident alien does receive a step-up in basis, which can provide significant tax benefits. However, it is important to comply with the tax reporting requirements in both the US and the foreign country to avoid penalties.

Capital gains tax

When an asset is inherited, the cost basis—the purchase price plus any additional costs incurred for improvements or maintenance—is adjusted to the fair market value at the date of the previous owner's death. This is known as a step-up in basis and can significantly reduce capital gains taxes for heirs when they sell the asset. For example, if an individual purchases a home for $100,000 and it appreciates to $250,000 at the time their heir inherits it, the heir will only pay capital gains tax on the difference between $250,000 and the sales price, rather than the difference between $100,000 and the sales price.

The step-up in basis rule means that inherited property is always treated as a long-term capital gain opportunity. This allows inheritors to avoid paying capital gains taxes on any appreciation that occurred before they inherited the property. Instead, the seller will only pay capital gains taxes on the appreciation in the property's value from the date of the owner's death.

It's important to note that not all assets receive a step-up in basis. Assets owned inside an IRA, 401(k), or other retirement accounts do not receive a step-up. Additionally, assets owned by most irrevocable trusts do not receive a step-up in basis unless they are included in the estate of the grantor or beneficiary.

Community property states

In the United States, community property laws apply to nine community property states, including California, and allow for a double step-up in basis rule. This means that a step-up in basis is allowed for community property—assets accumulated during marriage, excluding inheritances and gifts—for the surviving spouse. This is especially beneficial for the surviving spouse when they decide to sell the property, as it will significantly reduce their capital gains tax.

In non-community property states, assets owned solely by the surviving spouse do not receive the step-up in basis, while jointly owned assets receive only half the step-up in basis they would receive in a community property state.

In the context of estate planning, when a U.S. citizen spouse passes away and names a non-U.S. citizen spouse as the beneficiary, the non-U.S. citizen spouse can inherit property in the same manner as a citizen. However, under federal estate tax rules, a surviving spouse who is not a U.S. citizen must pay taxes on the inherited amount, as the unlimited marital deduction rule does not apply.

To address this, a U.S. citizen spouse can establish a Qualified Domestic Trust (QDOT) and name the non-citizen spouse as the beneficiary, allowing the citizen spouse to take advantage of the unlimited marital deduction. The QDOT can be created by the will of the decedent or elected within 27 months of their death. The trust will inherit the property instead of the non-citizen spouse receiving it directly, and the surviving spouse will be the sole beneficiary during their lifetime, receiving income from the trust.

When the non-U.S. citizen spouse passes away, and the U.S. citizen is the beneficiary, the property in their name will pass to the U.S. citizen spouse under the federal gift and estate taxes unlimited marital transfer exemption on all the money both own worldwide.

Retirement assets

For retirement accounts, such as IRAs or 401(k)s, the rules can be more complex. When a non-resident alien inherits a retirement account from a US citizen or resident, the beneficiary may be subject to different tax implications. In some cases, the beneficiary may be required to liquidate the retirement account and pay taxes on the distribution. In other cases, the beneficiary may be able to stretch the tax benefits of the retirement account over their lifetime.

It is important to note that the rules for inherited retirement accounts can vary depending on the country of residence of the beneficiary and the specific tax treaty between that country and the United States. Seeking professional tax advice is always recommended in these situations.

Additionally, the type of retirement account can also impact the tax implications. For example, Roth IRAs, which are funded with after-tax dollars, may have different rules compared to traditional IRAs or 401(k)s. It is crucial to understand the specific rules and regulations that apply to the type of retirement account being inherited.

In conclusion, while the step-up basis rule can provide significant tax benefits to beneficiaries of various financial assets, the treatment of retirement assets can be more complex, especially when dealing with non-resident alien beneficiaries. Seeking professional tax advice is essential to ensure compliance with the applicable tax laws and to make the most tax-efficient decisions.

Intentionally defective grantor trusts

An intentionally defective grantor trust (IDGT) is an estate planning tool used to freeze certain assets of an individual for estate tax purposes but not for income tax purposes. It is a grantor trust with a loophole that allows it to receive income from certain trust assets. The grantor pays income tax on any generated income, but the estate does not incur any estate taxes when the grantor dies.

IDGTs are often used when the beneficiaries are children or grandchildren, allowing the grantor to pay income tax on the growth of assets that they will inherit. The grantor's taxable estate can be reduced by the amount of the asset transfer, as the individual will "sell" assets to the trust in exchange for a promissory note, which can be set for 10 or 15 years. The note will pay enough interest to classify the trust as above-market, but the underlying assets are expected to appreciate at a faster rate.

The structure of an IDGT allows the grantor to transfer assets to the trust either by gift or sale. Gifting an asset could trigger a gift tax, so it is better to sell the asset to the trust. When assets are sold to an IDGT, there is no recognition of a capital gain, and therefore no taxes are owed. This is ideal for removing highly appreciated assets from the estate. The transaction is usually structured as a sale to the trust to be paid for with an instalment note over several years. The grantor can charge a low rate of interest, which is not recognised as taxable income.

However, the grantor is liable for any income that the IDGT earns. If the asset sold to the trust is income-producing, such as a rental property or a business, the income generated inside the trust is taxable to the grantor.

IDGTs are not taxed when assets are sold into them or if they appreciate because there is no recognition of capital gains. However, the grantor pays income taxes if there is income from the IDGT. If there was an instalment note, the principal and any accumulated interest are included in the grantor's taxable estate. However, if the assets were sold into the IDGT, they are not included in the taxable estate and can be passed on to the beneficiaries.

IDGTs can provide significant leverage by minimising the income tax burden of the trust's assets. However, this strategy is only effective if the grantor has adequate resources to continue to pay the trust's income tax liabilities. An IDGT should be undertaken with the close involvement of qualified legal counsel.

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