Basis step-up when property is subject to a power of appointment.

As a general rule, the basis of property in the hands of a person acquiring the property from a decedent is its fair market value (FMV) on the date of death (Sec. 1014(a)). In order to receive the step-up in basis, the property must have been includible in the decedent's gross estate (Regs. Sec. 1.1014-2(b)(2)). If the decedent possessed a "general power of appointment" over property at death, that property is includible in the estate (Sec. 2041). Such property is includible in the estate whether the power is exercised or released (i.e., not exercised). Therefore, such property is subject to the basis step-up at death to FMV.

A general power of appointment is defined as a power exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate (Sec. 2041(b)(1)). If the power of appointment is not expressly exercisable in favor of one of the above, it is considered a "special" power of appointment, and the value of the property is not includible in the estate. Finally, property subject to a general power will be included in a decedent's estate only to the extent that the property that could have been appointed by the exercise of the power the decedent allowed to lapse exceeds the greater of (a) $5,000 or (b) 5% of the total value of the property subject to the power at the time of lapse (Regs. Sec. 20.2041-3(d)(3)).

Obviously, if property subject to a power of appointment is not includible in the estate because the power is"special," the property does not receive a step-up in basis. These issues were recently addressed by the Tax Court in Prokopov, TC Memo 1997-229.

George Ogden died in 1981, leaving property in trust to his wife, Lucile. She was enticed to the trust income for life and a noncumulative annual right to withdraw the greater of $5,000 or 5% of the trust corpus. In addition, Lucile was granted the special power to appoint the principal of the trust to any of George's lineal descendants or their spouses.

Lucile died in 1990, without having exercised the annual withdrawal right. Since Lucile had the right at her death to appoint the greater of $5,000 or 5% of the trust corpus to her estate, her executor included 5% of the trust corpus in her estate. One asset that was included in the trust was real property worth $259,000 at George's death, but worth $600,000 at Lucile's death.

The real property was sold by the trust in 1992 for $600,000. The trustee used a basis of $276,000 in computing the gain. Along with the costs of sale, the gain was computed at $260,000, 30% of which was allocated to George and Lucile's daughter. The daughter did not report the gain from the sale of the real property as part of her taxable income. She argued that the property should have received a stepped-up basis on Lucile's death, because Lucile possessed a power of appointment over the trust corpus. The Tax Court dismissed this argument. Since all Lucile had with respect to the trust was a special power of appointment that provided that she could not transfer the trust assets to her estate, the real property was never transferable from the trust to her estate. As a consequence, the real property in the trust received no stepup in basis (other than the 5% allocable to the portion includible in her estate), and there was properly a gain when the real property was sold by the trust.

Comment: By granting someone a power of appointment over property, the estate owner is, in effect, postponing the decision on the ultimate distribution of property and assigning that decision to the power holder. The rationale for such action is that the holder of the power can better assess the needs of the potential beneficiaries when more facts are known.

From Boyd D. Hudson, Esq., Los Angeles, Cal. (not affiliated with AFAI)