Avoiding the Zero Basis Trap: Tax Planning Lessons from the Trail

On a recent family trip to the North Carolina mountains near Asheville, I discovered a mountain biker’s paradise in the Blue Ridge Mountains. My first evening ride was perfect, with great weather and pristine trail conditions. As the sun set, I stood at the trailhead, excitement building as I prepared for the adventure.

The climb up Ridgeline Trail was tough but rewarding, offering breathtaking views of emerald valleys and jagged peaks at the summit. After a brief pause to take it all in, I plunged down the mountainside, navigating hairpin turns and switchbacks with exhilaration. The wind roared, the forest blurred by, and every sense was alive as I descended. When the trail finally leveled out, I stopped, chest heaving, and looked back at what I’d just conquered. What a ride!

As I stood, catching my breath and soaking in the adrenaline-fueled satisfaction of the ride, my mind began to wander from the thrill of the trail to the complexities of life beyond the mountains. Just as navigating a rugged trail requires careful preparation and awareness of every twist and turn, so too does navigating the legal and financial landscape that awaits us off the bike. Life’s paths, much like those mountain trails, can be unpredictable with unexpected challenges waiting around each corner. This brings me to a different kind of challenge—one that many face after the passing of a loved one: understanding the intricacies of inheriting property and the potential tax implications that come with it.

When someone inherits property from a deceased person, they usually get a tax basis equal to the property’s fair market value at the time of death (or six months later if using an alternate valuation date) [IRC 1014(a)]. However, under the “basis consistency reporting rules” proposed in 2016, the inherited property’s tax basis might end up being $0.00, which could surprise the heir who was expecting a stepped-up basis.

Proposed Regulations: The proposed regulations under IRC 1014(f) emphasize that the tax basis of inherited property must be consistent with the value reported for federal estate tax purposes. This means the tax basis can’t exceed the property’s value as determined for estate tax purposes.

Final Value: The “final value” of property for federal estate tax purposes is:

• The value reported on a federal estate tax return that isn’t contested by the IRS before the limitation period ends (typically three years from the return’s due date, or six years if there’s a 25% or more omission from the gross estate).
• There’s no limitation period if no federal estate tax return is filed.

Zero Basis: A $0.00 tax basis can occur if property is discovered after the estate tax return is filed, if it was omitted from the return, or if no required estate tax return was filed.

“Would Result in”: The consistent basis rules only apply to property that would cause or increase estate tax liability if included in the gross estate. If property was omitted from the estate tax return and would have increased estate tax liability, its tax basis is considered $0.00.

• Too Late to File: A supplemental estate tax return can only be filed within the assessment period. If this period has passed, it might be too late to correct the tax basis to avoid a $0.00 basis.
• No Return Filed: If a required federal estate tax return isn’t filed, the final value of all property subject to the consistent basis requirement is considered $0.00 until an estate tax return is filed.

Basic Traps: The consistent basis reporting rules highlight the importance of identifying and valuing all assets of the deceased to ensure the heirs can claim a stepped-up tax basis.

• Example #1: After Daine’s death, an unreported investment account is discovered. Since it wasn’t included on the estate tax return, the tax basis for her grandson Trevor, who received the account, is $0.00. If Trevor sells the investments, he’ll owe taxes on the full sale amount.
• Example #2: James’ estate didn’t obtain appraisals for some partnership interests, believing the estate was below the exemption amount. If the IRS later finds that an estate tax return should have been filed, the partnership interests might have a $0.00 basis, and penalties could apply. Obtaining a later appraisal could be difficult and expensive.

Personal representatives and trustees must carefully identify and value a decedent’s assets and be diligent about filing federal estate tax returns when required. They should also educate heirs about the importance of these steps even if it means spending some of the inheritance on appraisals and taxes.

In the end, just as a successful mountain bike ride requires awareness, preparation, and an understanding of the terrain, so too does managing the complexities of inheritance and tax implications. The exhilaration of the ride may be fleeting, but the lessons learned on the trail are lasting—reminding us that whether we’re navigating rocky paths or the intricate rules of estate planning, attention to detail and proactive decision-making are key. For those entrusted with the responsibility of managing an estate, the stakes are high. Ensuring that all assets are properly accounted for, and the necessary steps are taken to protect the financial well-being of heirs is crucial. By embracing these responsibilities with the same determination and focus required on the trail, personal representatives and trustees can help ensure a smoother ride through the often challenging landscape of inheritance.