“Our Greatest Hits” is an effort to show our readers the most popular – and still avidly read – articles from our archives. This article originally appeared in our September 1991 Issue.
Abstract – Beneficiaries of an estate or trust, whose taxes are based on Sec. 643(e)(3) of the Internal Revenue Code, should consider the consequences of present and future taxes in a fiduciary’s decision as to whether to make the election recognize distribution losses or gains. Factors to consider in opting for election are: the likely effects of Sec. 1239, depreciation recapture, deductibility of losses, changing character of the income, capital offset carryovers to offset gains, possibility of loss usage for the estate, beneficiary’s usage of capital gains for loss carryovers, time value of money, and beneficiaries’ health and age.
When property (instead of cash) is distributed from an estate or trust, the code provides two methods for determining the amount taxable to its beneficiaries under Sec. 662(a)(2) and deductible by the fiduciary as a distribution deduction under Sec. 661(a)(2). The method decided upon by the executor or trustee in computing its distribution deduction will also effect the beneficiary’s tax basis in the property received in distribution.
As provided in Sec. 643(e)(1), a beneficiary’s basis in property distributed by an estate or trust after June 1, 1984, will be the adjusted basis of such property in the hands of the estate or trust prior to distribution adjusted for any gain or loss recognized by the estate or trust upon distribution. Generally, a distribution of property in kind does not result in the recognition of a gain or loss to theestate or trust unless the distribution is in satisfaction of a pecuniary (fixed-dollar) gift or bequest. Therefore, where no gain or loss is recognized, the income tax basis of the property received by the beneficiary would be the estate’s or trust’s adjusted basis prior to the distribution.
An Election is Possible
However, Sec. 643(e)(3) provides that a fiduciary may irrevocably elect to recognize gain or loss on the distribution, as if the property distributed had been sold to the beneficiary at its fair market value on the date of the distribution. If such an election is made, the income tax basis of the property received by the beneficiary would be the adjusted basis of such property in the hands of the estate or trust prior to distribution adjusted by the gain or loss recognized by the estate or trust on the distribution. (The election shall be made on the fiduciary return for such taxable year, and shall apply to all distributions made by the estate or trust for that year. Once made, the election may not be revoked without the consent of the IRS.)
As previously mentioned, the decision as to whether or not to make the election will also effect the amount allowable as a distribution deduction to the estate or trust under Sec. 661(a)(2) and the amount that the beneficiary reflects as income under Sec. 662(a)(2). If the fiduciary does not make the Sec. 643(e)(3) election, then the estate or trust’s distribution deduction and the amount included in the beneficiary’s gross income is based upon the lesser of 1) the basis of the property in the hands of the beneficiary, or 2) the fair market value of the property at the time of the distribution. If the election is made, then the fair market value is used in determining the entity’s distribution deduction and the amount the beneficiary must include in income. Of course, the amount allowable as a distribution deduction and includable by the beneficiary as incomes is limited to DNI.
Factors to be Considered
In determining whether to make the election under Sec. 643(e)(3), the fiduciary must consider the present and future tax consequences to the estate or trust and to the beneficiary. In doing so, the fiduciary should consider the type of gain that would result if such an election is made. In certain instances, the election may produce ordinary income that is considered in arriving at the DNI, as opposed to capital gain, which generally is not part of DNI. Some of the major factors that should be considered are:
1. Consider the possible effects of Sec. 1239. Under Sec. 1239(a), gain on the sale of depreciable property between related parties is ordinary income. Although estates and their beneficiaries are not considered related parties for Sec. 1239 purposes, trusts and their beneficiaries are related under Sec. 1239(b)(2).
2. Don’t forget depreciation recapture. The depreciation recapture rules under Secs. 1245 and 1250 also result in the production of ordinary income and should be considered when distributing depreciable property.
3. Losses may not be deductible. Under Sec. 267(a), loss on the sale of property between certain relatec taxpayers is not recognized. A trust and its beneficiaries are related parties under Sec. 267(b)(6). Therefore, if a trustee distributes property with a fair market value less than its basis and makes the 643(e)(3) election, the trust cannot recognize the loss. An estate and its beneficiaries are not related taxpayers for Sec. 267 purposes.
4. The character of the income may be changed. The amount as well as the character of income taxable to the estate or trust and to the beneficiary may also be affected by the election. For example, if the estate or trust has DNI of $10,000 and the fiduciary elects to recognize gain under Sec. 643(e)(3) on the distribution of appreciated property having a FMV of $6,000 and an adjusted basis of 2,500, the beneficiary will receive a basis of $6,000 in the property and will recognize ordinary income of $6,000. However, if the election is not made, the beneficiary will have a basis of $2,500 in the property and will recognize income on the distribution of only $2,500. Therefore, by making the election, the beneficiary is taxed currently on an additional $3,500 of ordinary income which could have been deferred as unrecognized capital gain.
5. Loss carryovers may help. Consider whether the estate or trust has capital loss carryovers from prior years to offset any gains triggered if the election is made upon the distribution of appreciated property.
6. Consider whether the estate can use the loss. An executor may consider making the election if losses can be triggered, upon the distribution of depreciated property, to offset other gains realized during the year.
7. Consider whether the beneficiary can use capital gains to any loss carryovers. If the beneficiary has a substantial loss carryover, the executor or trustee should consider a distribution of appreciated property without making the election and have the beneficiary sell the appreciated property when received.
8. Perhaps the beneficiary can use losses. If the beneficiary needs capital losses, the fiduciary should consider distributing depreciated property without making an election in order for the beneficiary to recognize losses upon sale of the property received in distribution.
9. Consider the time value of money. If the beneficiary has no current intention of selling appreciated property received in distribution, it may be advisable to forego making the election in order to defer payment of taxes attributable to the increase in value.
10. Consider the health and age of the beneficiaries. Don’t forget that upon the beneficiaries’ deaths appreciated property will get a tax- free step-up in basis of its fair market value.
There may be other considerations of relevance in the fiduciaries’ decision of making the election. The fiduciary should exercise its discretion carefully due to the significant tax ramifications to itself, the current beneficiary, and the ultimate beneficiary or remainderman.
Passive Losses For Estates and Trusts in the Year of The Decedents Death
If an investment in a passive activity is disposed of in a fully taxable transaction to an unrelated person prior to the death of the taxpayer, all of the current year’s passive loss and the suspended passive losses are allowed as deductions against other income. A net loss from the disposition is not treated as a loss from a passive activity.
However, when an investment in a passive activity is transferred to an estate because of the death of the taxpayer, suspended losses are allowed only to the extent they exceed the amount, if any, to which the basis of the interest is increased at death under Sec. 1014. For example, if the basis of the investment is $10,000, and its fair market value for estate tax purposes is $15,000, then the $5,000 increase reduces the suspended losses on the final return of the deceased taxpayer. Any losses to the extent not allowed are not allowed as deductions in any tax year.
There are special rules relating to the $25,000 passive loss exemption: “If the decedent and the executor or other fiduciary person actively participated in rental real estate activities, then the estate will be able to use the $25,000 exemption for the taxable years ending less than two years after the death of the decedent. The amount of the $25,000 exemption available to the estate is reduced by the amount of the exemption used by the surviving spouse (or the amount that would have been used if not for the phase-out for high-income taxpayers) in the taxable year ending with or within the estate’s taxable year.