ESTATES AND TRUSTS

June 2000

SELLING A DECEDENT'S REAL ESTATE: SOME TAX CONSIDERATIONS

By Lainie R. Fastman

When an individual dies, apparently owning an interest in real estate, beneficiaries, devisees, and the personal representative of the estate have to consider a number of tax questions. The fiduciary must determine the date of death market value for estate tax purposes.

The fiduciary is charged with paying the funeral expenses, estate taxes, and administrative expenses, and real property may need to be sold to effect that goal. The fiduciary must also decide whether the expenses of sale are deductible administration expenses. This is not always the case. Once the property is sold, who must report gains and losses and how they are measured becomes important.

Administration Expenses

New York's Estates Power and Trust Law (EPTL) section 13-1.3(a) provides that all of a decedent's property, personal as well as real, is chargeable with the payment of administration and reasonable funeral expenses, debts of the decedent, and any taxes for which the estate is liable.

EPTL 11-1.1 grants the administrator or executor sweeping powers with respect to real estate, including the power of sale. The Surrogate's Court Statute provides that the exercise of such powers must be necessary to distribute the property or to pay estate taxes and funeral and administration expenses.

The first order of business is to determine the taxable estate. In the case of joint tenants other than spouses, the value of the entire property is taxed in the estate of the first joint tenant to die, unless the survivor can establish a contribution to the original purchase price. Where interest in real property is held jointly with a surviving spouse and was acquired in 1977 or thereafter, only one-half the interest is taxable in decedent's estate and that half is eligible for the marital deduction pursuant to IRC section 2056, unless the surviving spouse is a noncitizen. Property jointly acquired by decedent and spouse prior to 1977 is entirely taxable in the estate of the deceased spouse and is eligible in its entirety for the marital deduction pursuant to IRC section 2056.

Subject to certain exceptions, all property held jointly with a surviving noncitizen spouse is taxable in the estate of the decedent. The property is valued as of the date of death, and customarily the fiduciary will obtain an appraisal from a reputable appraiser. Notwithstanding an appraisal, the price obtained from a sale to a bona fide purchaser for value within a reasonable period of time after decedent's death is the best evidence of market value for estate tax purposes [IRC section 2031; Estate of J.E. Bond, 25 TCM 115, Dec. 27, 826(M), T.C. Memo, 1966-21].

A decedent who retained a life estate will be deemed the owner of the entire parcel for estate tax purposes, pursuant to IRC section 2036(a); as will the decedent in possession of a general power of appointment pursuant to IRC section 2041 or a power to alter, amend, revoke, or change beneficiaries, pursuant to IRC section 2038. A deed to decedent's children, where the decedent retained the power to appoint a different grantee (as is now seen on occasion where the decedent engaged in so-called Medicaid planning) is just such a power.

Should the decedent have paid any gift taxes at the time she made the gift with retained interest, credit will be given on the estate tax return [IRC section 2001(b)]. Often, the donor will have used the exemption on the gift tax return and no actual gift tax will have been paid.

Unless the decedent directs otherwise in her will, the estate tax is apportioned among the beneficiaries of her estate; each asset being burdened by the amount of tax proportionate to the value of the interest, in accordance with EPTL section 2-1.8. It also provides that an interest eligible for the charitable or marital deduction is not burdened by a proportionate share of estate tax.

Administration expenses incurred in the sale and maintenance of real property, such as broker's commissions, appraiser's fees, and real property transfer taxes, are deductible on the estate tax return or, if the fiduciary so chooses, in the estate's fiduciary income tax return (IRC section 2053). Treasury Regulations section 20.2053-3(d)(2) provides that a deduction of expenses incurred in selling property is permitted only if such costs are necessary to

1) pay the decedent's debts, administration expenses, or taxes;
2) preserve the estate; or
3) effect distribution.

Often, the estate tax return will be filed before a sale has actually taken place. In such cases the anticipated, reasonable costs of sale are, nevertheless, deductible. In one case, an estimated deduction was disallowed because the sale had not taken place four years after decedent's death and no record was presented indicating any effort to sell, such as advertising of the property for sale (Estate of Gertrude F. Koss v. Comm'r, T.C. Memo 1994-599).

In determining whether to allow the deduction for administration expenses related to sale or maintenance, the IRS will look to local law, which, in the first instance, must permit the deduction. Even if allowed under local law, the IRS may disagree. In Estate of Melville (T.C. Memo 1993-484) the Surrogate's Court awarded executors' commissions where a sale had not taken place, but the executor had executed the deed. The deduction was disallowed.

In Estate of Miliken v. Comm'r [125 F.3d 339 (6th Cir., 1997)], the Circuit Court of Appeals held that Treasury Regulations section 20.2053(a) imposes an additional Federal requirement for deductibility other than allowance under state law. This effectively overruled a New York State case which, in reliance on an earlier Sixth Circuit case, had solely applied New York State Law [Estate of Rudolph Lagergren, 631 N.Y.S.2d 234, Surr. Ct. Nassau Cty. (1995)]. To be deductible, expenses incurred in the administration of the estate must be "actually and necessarily incurred in the administration of decedent's estate, that is, in the collection of assets, payment of debts, and distribution of property to the persons entitled to it." The Second Circuit is in agreement [Estate of Smith v. Comm'r, 510 F2d 479 (1975)]. In short, the expenses of sale must be necessary, not merely permissible, under state law.

Up to $250,000 could have been deducted on the New York State estate tax return if the value of the decedent's personal residence was included in the taxable estate (Tax Law section 955). The deduction is reduced by any deductible expenses related to the residence taken on any other schedule of the return. Effective February 1, 2000, this deduction is no longer applicable (chapter 389, laws of 1997).

Gains and Losses

When the beneficiary acquires the decedent's real property, she acquires the decedent's date of death market value, as determined for estate tax purposes, as her tax basis. Regardless of the tax basis in the decedent's hands during her lifetime, her beneficiary acquires a step-up in basis upon decedent's death [IRC section 1014 (a)(1)]. The surviving spouse who held property acquired jointly before 1977 will be entitled to a full step-up in basis [Gallenstein M. Lee v. U.S., CA 6, 975 F2d 286 (1992); Therese Hahn v. Comm'r, 110 TC No. 14 (1998)]. The surviving spouse acquiring property after 1977 will receive a step-up in basis with respect to one-half the property, the other half constituting her own property and therefore, bearing her own basis.

Assume a decedent purchased property for $20,000 and dies 10 years later, at which time the property is worth $100,000. If the beneficiary sells the real property for $100,000, no gain is reportable.

Should the beneficiary sell the property 1 wQ years later for $150,000, she must report a $50,000 gain. If the estate had made the sale within a reasonable period of time after decedent's death, the $100,000 sales price occasions no gain. A sale 1 wQ years after death for $150,000 may result in a $50,000 gain reportable in the fiduciary income tax return (Form 1041), unless the estate can persuade the IRS that the market value taken in the estate tax return at decedent's death was unrealistic. (The audit will then result in an increase in the taxable estate.)

What if the property is sold at a loss? For example, assume that the decedent's real estate is her personal residence, a common situation. Various interrelated provisions of the IRC are at issue. IRC section 641(b) provides that an estate shall compute its taxable income in the same manner as in the case of an individual. An individual may not deduct losses in the sale of a personal residence on her personal income tax return. If, however, the beneficiary has made immediate attempts to rent or sell the residence, the residence is converted into a capital asset. A loss from the sale of a capital asset shall be allowed as a deduction under IRC section 165(a) but with certain limitations.

Two years ago, the Brookhaven, N.Y., IRS Service Center confronted a number of fiduciary income tax returns on which the fiduciary had reported losses from the sale of decedent's personal residence. In an IRS service center advice memorandum (SCA 98 TNT104-82, 6/1/98), the IRS concluded that the deductions were improper. The returns filed permitted the losses to flow through to the estate's beneficiaries on Form K-1, which, in turn, offset the beneficiary's income tax. The memorandum commenced by reiterating that an estate may not deduct a loss incurred on the sale of the decedent's personal residence unless it has been converted to an income-producing asset [IRC sections 641(b) and 165(c)].

State law determines ownership of the property and therefore the person who can report the loss. In the case of joint tenants with right of survivorship, the surviving joint tenant may properly recognize the loss on her personal return [Peterson v. Comm'r, 35 T.C. 962 (1961) as cited in 98 TNT 104-82, 6/1/98].

In cases where specifically devised real property must be used in order to satisfy estate obligations, the fiduciary may report the loss in Form 1041 in proportion to the percentage of the proceeds used by the estate to satisfy the estate's obligations. The balance should be reported by the devisees in their personal returns.

The service center advice memorandum illustrates: If 50% of the proceeds from the sale of the decedent's personal residence is used to satisfy the obligations of the estate, the estate should report 50% of the loss recognized on the sale on the 1041 and the devisees should report the remaining 50%. This same calculation is applicable if a sale of real property must be resorted to and the property passed in intestacy. The heirs will report their proportionate share of loss in their personal returns. The fiduciary may properly report losses in the Form 1041 [(Brown v. Comm'r, 20 T.C. 73 (1953)].

The final question answered by the service center advice memorandum is how the amount of loss is fixed. To determine this, the estate must establish the fair market value at the time of conversion into a capital asset. The excess of the adjusted basis pursuant to Treasury Regulations section 1.1011-1 over the amount realized determines the deductible loss. The losses do not flow directly to the beneficiaries from the estate but, instead, are used in determining the estate's taxable income. The estate may then deduct amounts paid, credited, or required to be distributed to its beneficiaries pursuant to IRC section 661. This deduction is limited to the amount of the estate's distributable net income (DNI) as defined in IRC section 643(a). The beneficiaries of the estate must then report on their individual returns the DNI payable to them.

The issue of who may report the loss is now applicable. To the extent that the estate's loss on the sale of the decedent's residence, converted into a capital asset, is includable in the estate's DNI, the beneficiary is entitled to claim a proportionate share of such loss. To the extent that a loss is treated as an item taken into account in determining the estate's taxable income, it should be reported in the fiduciary income tax return. And, as noted previously, to the extent it is not, it should be reported in the personal income tax return in the year of the sale by the surviving joint tenants, heirs, or devisees, which are treated as the owners of the property under state law. *