Many individuals have questions about the US tax consequences of foreign (non-US) assets inherited from a non-US individual who has passed away. They want to know whether US tax reporting is required, or if they must pay US tax on the inheritance. Some ask about the US tax upon a later sale of the inherited property. Some individuals are US beneficiaries of a foreign trust created by the decedent and receive property directly from the foreign trust (my earlier blog post explains what the tax law means by a “foreign” trust – it’s complicated!!). Today’s post will focus on the tax concept of “basis” and inherited foreign property. First, some “basis” basics and an explanation of why “basis” is so important.
When giving assets to loved ones (or receiving them), it is important for US tax purposes to understand the pros and cons of lifetime gifts versus an inheritance. Basis plays into these scenarios in a very critical way.
When a US person receives cash or other valuable assets as a lifetime gift or as an inheritance (whether from a US or non-US individual or estate), the recipient will not owe US income tax on those assets. This is true regardless of the amount, whether the gift is given during the lifetime of the donor or, if it is received as an inheritance. Bona fide gifts or bequests are not subject to income tax in the hands of the recipient because of a special exemption under Section 102 of the US Internal Revenue Code. Of course, there are always some surprising exceptions…. and here’s another one.
The individual donor (even if a foreigner) may owe a US gift tax upon making the gift, and the estate (even if the estate of a foreigner) may owe a US estate tax, but as a general rule, the recipient does not owe a tax upon the receipt of the gift/bequest. My blog post here – provides a succinct explanation of the differing US Estate & Gift Tax rules for US and non-US persons.
What is “Basis” and Why Should I Care?
Let’s take an example to understand the concept of “basis” and its importance: Assume an individual receives a non-cash asset as a gift or inheritance (for example, stock in a company or an art work) and subsequently sells that asset, the individual will incur US income tax consequences upon the sale. The extent of the tax consequences depends on his “basis” in the asset received. Basis is essentially the original cost of property, adjusted for various factors like depreciation.
Under current law, the “basis” rules are different as they relate to gifts received from the giver during his or her life and gifts received as an inheritance. The different types of basis are referred to as a carryover basis and stepped-up basis.
Carryover basis – When an individual receives an appreciated asset as a gift, he also receives the giver’s basis in that gift. This means that the previous owner’s basis “carries over” to the recipient.
Here is a very simplified example: You invested $10,000 in X corp. stock many years ago. When the shares are worth $19,000, you gift those shares to your son. Son retains your $10,000 basis in the shares. If he sells the shares for $22,000, he will owe tax on the $12,000 gain instead of owing tax on the $3,000 gain since the gift was made.
Stepped-up basis – Different rules apply to inherited assets. Here, the heir’s basis typically is the value of the asset on the date of death of the owner. It is “stepped up” to the fair market value on date of death.
Using the above example, assume you die and the stock is worth $200,000 at your death. Even though your basis in the shares was only $10,000, son’s basis in the shares is $200,000, which was the value when you died. Son will have no taxable gain on a subsequent sale for $200,000. He would have a $10,000 gain on a sale for $210,000.
Will a US Taxpayer get a Basis “Step-up” at Death of a Foreign Individual?
What happens when property is received from a nonresident alien (NRA) decedent? The very generous rule permitting a basis step-up at death will generally apply, but as usual there are details in the tax rules. Property received directly from a NRA decedent generally takes a basis in the hands of the beneficiary equal to the fair market value of the property as of the date of the NRA’s death. See IRC Section 1014(b). This favorable rule applies regardless of whether or to what extent the property was included in the NRA decedent’s US taxable estate. See Rev. Rul. 84-139, 1984-2 C.B. 168 which held that real estate located in a foreign country that is inherited by a US citizen from a nonresident alien will receive a step-up in basis even though the property is not includible in the value of the decedent’s US gross estate (therefore, it escapes US estate tax). This is an extremely generous tax result.
Assets in Foreign Trusts
Below is a very general overview of an extremely complicated topic. When assets are not received directly from the NRA-decedent, but instead for example, through a foreign trust some complexity arises with respect to the issue of basis. When dealing with a revocable “foreign grantor trust” (FGT) created by a deceased NRA, the revocable trust generally receives a basis adjustment of its assets upon the NRA’s death if the NRA retained the power to revoke the trust as well as the power to direct or order income distributions from the trust. (IRC Section 1014(b)(2)). With respect to irrevocable trusts created by a NRA that qualify as a FGT, the matter becomes even more complicated. Generally, the basis step-up rule does not apply to assets that were transferred, within the meaning of the estate tax rules, prior to the decedent’s death. So, for example, property transferred by an NRA before death to an irrevocable trust will raise special concerns.
What Now that Mr. Biden May Eliminate Basis “Step-up” at Death?
Tax proposals of President-elect Biden indicate he plans to do away with the “step-up” in basis heirs receive for inherited assets. This proposal may not become law and so, tax planning in this regard should not be ignored. If the law is changed, it is an important reminder that tax laws change time and time again. Trust documents should always be reviewed in light of the latest law changes. Finally, depending on the precise facts of each case, it may be possible to avert a large US capital gain for heirs and trust beneficiaries by “stepping-up” the basis in certain assets by a sale and later re-purchase by the foreign donor or by the trust. Of course, an efficient use of this technique requires that the tax impact of any relevant other country (e.g., the home country) not be ignored.
Generally speaking tax planning opportunities, even in difficult circumstances, may be possible if you use the right tax advisor. With decades of experience in US tax matters, I am here to help you.
Posted December 30, 2020
All the US tax information you need, every week –
Just follow me on Twitter @VLJeker (listed in Forbes, Top 100 Must-Follow Tax Twitter Accounts 2017-2020).
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
Visit my earlier US tax blog “Let’s Talk About US Tax” hosted by AngloInfo since 2011, it contains all my old posts. Some hyperlinks to my blog posts on AngloInfo may have expired. If you copy the expired URL, you can most likely retrieve the actual post by using the “Wayback Machine” which is an archiving service. Simply paste the URL into the Wayback Machine search box. It will show you the archived post was saved on a specific date. Click on that date to retrieve the post.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920
Virginia - US TAX TALK 