No step-up in basis for installment notes.

Generally, under Sec. 1014(a)(1), property acquired or passed from a decedent has a basis equal to its fair market value at the time of the decedent's death. If the property is sold shortly after its basis has been stepped up, there is usually little or no gain or loss to be recognized, since in most cases the tax basis will approximate the sales price. The basis step-up rule applies to most properties acquired from a decedent. In addition, property that represents a surviving spouse's half share of property held by the decedent and the surviving spouse under the community property laws of any state also receives a basis step-up if at least half of the community interest in that property was includible in determining the value of the decedent's gross estate (Sec. 1014(b)(6)). However, the Code specifically excludes from the application of this rule property that constitutes a right to receive income in respect of a decedent (IRD) under Sec. 691. Included in the definition of IRD is an installment obligation reportable by the decedent under the installment method of reporting of Sec. 453. A taxpayer unsuccessfully tried to obtain a basis step-up in the case of Holt, Ct. Fed. Cls., 11/10/97.

In that case, H and W sold three condominium units in 1986, realizing a gain of $265,000 on the sales. The purchasers of each unit made a down payment, signed a promissory note for the balance of the purchase price, and gave H and W a deed of trust to secure the note. H and W elected to report the gains using the installment method of accounting under Sec. 453, which allowed them to pay the tax due on the gain as the sale proceeds were received each year, rather than as a lump sum in the year of sale.

H died in 1987. W continued to report the gain from the installment sales as the payments were received in accordance with the installment agreement; by 1993, all three notes had been paid in full. In 1994, W and her new husband filed amended returns to claim refunds, contending that they had erroneously included the installment payments received, from the 1986 sales in the years subsequent to H's death in gross income. The taxpayers argued that they should not have had to recognize gains on the payments received after H's death, as W was entitled to a step-up in basis in the installment notes at H's death in 1987.

The taxpayers argued that the installment notes were property in the same manner that the condominium units were property and thus constituted "investment assets" that warranted a step-up in tax basis at H's death. The Court of Federal Claims found no merit to this argument, ruling that the sale of the condominium units at a gain gave H and W the right to a stream of payments. This payment stream was an item of IRD that gave no right to a step-up in basis.

The taxpayers also argued that Sec. 1014(b)(6) gave W a step-up in basis in her half of community property at H's death; because H had passed his one-half of the community installment notes to W, both halves should receive a step-up in basis. Instead, the court found that Sec. 1014(c) supported the position that property in the hands of a decedent that represented a right to the receipt of income must be regarded as retaining that character in the hands of a transferee.

Although there is no step-up in basis in property that constitutes IRD, transferees who include IRD in gross income are entitled to a deduction under Sec. 691 (c) for the estate taxes attributable to the inclusion of such property in the decedent's estate. Thus, to the extent there was estate tax attributable to the inclusion of the installment notes in H's estate, W would be entitled to an itemized deduction (reported on Schedule A, Form 1040) for such estate tax in the year(s) the installment payments were received. Such deduction is not limited by the 2%-of-adjusted gross income rule.