National Association of Realtors
Washington, DC 20001
March 22, 2001

Honorable Bill Thomas, Chairman
Committee on Ways and Means
1100 Longworth House Office Building
House of Representatives
Washington, DC 20515

Dear Mr. Chairman:

The National Association of Realtors (NAR) appreciates the opportunity to comment on features of President Bush's tax cut proposal. The National Association of Realtors represents more than 760,000 Realtors who are engaged in every facet of real estate brokerage, leasing, property management and sales.

Our members generally favor low tax rates. Presently, they are hopeful that Congress and the Administration can strike a balance between tax cuts and reducing the debt. Real estate is particularly sensitive to interest rates, and we believe that the combination of tax and fiscal policy should foster the lowest possible interest rates and tax rates.

Two features of the President's tax cut plan are the subjects of hearings on March 21. NAR wishes to express concerns about marriage penalty relief and about some technical aspects of estate tax repeal.

Marriage Penalty Relief

NAR supports the marriage penalty relief specified by both Candidate Bush and in the Administration's "Blueprint for New Beginnings" (the budget plan). The budget plan reinstates the Reagan solution to the marriage penalty. The proposal allows a deduction for two-earner families that allows the lower-earning spouse to deduct 10 percent - up to $3,000 - of the first $30,000 of income. An identical provision was in effect from 1981 - 1986. The provision was repealed as part of the Tax Reform Act of 1986 because the low tax rates enacted in that legislation significantly reduced the impact of the marriage penalty. Since 1986, however, tax rates have increased and the marriage penalty has again become an anomaly of the Code.

NAR favors the Bush budget solution to the marriage penalty over methods that focus on the standard deduction. In 1999 and 2000, the House passed marriage penalty relief that would have doubled the standard deduction. Thus, the provision would have gone beyond the scope of simply reducing the marriage penalty by providing tax reductions to couples who do not experience the penalty because only one spouse earns income. Doubling the standard deduction is a simple method for addressing this problem, but it excludes working couples who itemize their deductions. We cannot discern any policy reason why those families who itemize should be denied marriage penalty relief.

NAR believes that two-income families who itemize their deductions should also receive marriage penalty relief. We believe that fundamental fairness requires this result. Therefore, we support the Administration's budget proposal over relief methods that focus on the standard deduction.

Provisions similar to those found in this year's H.R. 6 were advanced in 2000 to correct the marriage penalty. Those provisions were vetoed in 2000. This year, H.R. 6 doubles the standard deduction, widens the 15% bracket and mitigates the marriage penalty in the earned income credit. The sponsors of H.R. 6 acknowledge that it provides no relief to individuals who itemize their deductions. They attempt to correct this disparity by widening the 15% bracket for married joint filers. While this will provide relief to all married taxpayers, including those in higher brackets, we note that those who utilize the increased standard deduction will also receive the benefit of the bracket changes, while those who itemize will receive only the relief of the bracket widening. Moreover, since the bracket widening provision is phased in, it will take several years before taxpayers who itemize will receive relief. Again, we can find no policy basis for providing immediate relief to non-itemizers while providing only a single form of phased-in relief to itemizers.

Estate Tax Repeal - Support for H.R. 8 as Introduced

When H.R. 8 was debated in Congress in 2000, NAR sent House and Senate members a letter of support for final passage of the conference report on the bill but expressed concerns about that bill's provision eliminating stepped up basis in favor of carryover basis. In this Congress, Mrs. Dunn and Mr. Tanner have again introduced H.R. 8 and have retained stepped up basis. NAR strongly supports repeal of the estate tax and thus supports H.R. 8 in its current form. We believe that the Committee should adopt H.R. 8 in its current form, as it achieves both objectives of repealing the estate tax and retaining stepped up basis for all assets.

Challenges of Carryover Basis

Because Congress has passed carryover basis once, however, we wish to express our concerns about many of the problems associated with that change. Our concerns about carryover basis are based largely on administrative challenges for property owners, estate administrators and tax administrators. We believe that carryover basis is unduly complex. Indeed, the carryover basis provisions enacted in 1976 were delayed in 1978 until 1980. The Joint Committee "General Explanation of the Revenue Act of 1978" noted that

Congress believes that it should thoroughly review the concept of carryover basis in addition to considering its effect on the administration of estates. The Congress believes that the effective date should be postponed in order to review the provisions before they become effective. (General Explanation, p. 294.)

Congress undertook that review, and concluded that while carryover basis was perhaps a supportable policy, it was almost impossible to implement. Thus, the carryover basis rules were never put into effect and were repealed in the 1980 Crude Oil Windfall Profit Tax Act of 1980. In fact, the IRS and practitioners were unable to design rules to make the carryover basis concept operational. The Joint Committee "General Explanation of the Crude Oil Windfall Profit Tax Act of 1980" that accompanied the repeal of carryover basis described the "Reasons for Change" as follows:

A number of administrative problems concerning the carryover basis provisions have been brought to the attention of the Congress. Administrators of estates have testified that compliance with the carryover basis provisions has caused a significant increase in the time required to administer an estate and has resulted in raising the overall cost of administration. Congress believed that the carryover basis provisions are unduly complicated and should be repealed. (General Explanation, p. 120)

Advocates of carryover basis have expressed concern that the repeal of the estate tax, coupled with retention of stepped up basis, would permit substantial amounts of built-in gain in appreciated assets to completely escape taxation. Their concerns must be weighed against the problems inherent in designing workable carryover basis rules.

Even when the estate tax is repealed, the effects of inheriting assets will still be felt by heirs because the assets that the heirs receive will remain subject to the income tax rules. Thus, rules for determining the value of the assets that the heirs receive are essential. Current law permits the heirs to receive assets at their fair market value by providing a stepped up basis. Carryover basis requires that the heirs receive the assets at the value they have in the hands of the decedent.

The vetoed 2000 version of H.R. 8 would have permitted a stepped-up basis for $1.3 million of assets. All other assets would be subject to carryover basis. This rule has an effect similar to an exclusion and would eliminate the complexity of carryover basis for smaller, relatively simple estates. This year, Senator Kyl, an advocate of carryover basis, has introduced S. 275, which repeals the estate tax and institutes carryover basis, subject to a stepped up amount of $2.6 million per decedent. Thus, under S. 275 a couple could convey assets with a value of up to $5.6 million with a stepped-up basis. This provision will eliminate some of the challenges of carryover basis and will reduce the number of taxpayers subject to the carryover basis regime. The remainder of estates and their administrators and heirs will, however, face new complexities. The discussion that follows enumerates some of the problems with carryover basis and/or a part step up, part carryover model.

Recordkeeping: Carryover basis requires meticulous recordkeeping. Heirs will need to know when an asset was acquired and at what price. Additional costs arising from acquisition might also have changed the basis of the asset. These costs could include items such as commissions paid, title search costs and legal and/or financial advice related to the acquisition. In the case of stocks and other securities, the heir would need to know whether there had been splits and/or mergers or acquisitions that applied to the stock. In the case of real property or certain tangible personal property, the heir would need to know the costs of improvements and repairs, as well.

Some would say that this is no different from the information the recipient of a gift would need to have because gifts are subject to a carryover basis. The stark difference between a gift and a bequest, however, is that the donor is alive and able to provide information in the case of a gift, but the person with all the information is dead in the case of a bequest and so cannot provide information.

Liabilities in Excess of Basis: Under current law, the amount property that is subject to the estate tax is the net value of the property in the estate. Thus, in a taxable estate, an individual might have a property with a fair market value (FMV) of $4 million at death, a basis in that property of $300,000, and a debt on the property of $3 million. The estate tax on this property would be imposed on a value of $1 million - the net FMV of the property ($4 million less $3 million debt.). If an heir later sold the property for $4.5 million, the taxable gain would be $500,000 ($4.5 million sales price less stepped up basis of $4 million). The debt would have no effect on the stepped up basis of the heir at the time of disposition.

By contrast, the transfer of a debt-encumbered property with a FMV of $4 million, debt of $3 million and a basis of $300,000 would be treated much differently under carryover basis. The heir would have a basis in the property of only $300,000 (the same as the decedent's). A subsequent sale of the property for $4.5 million would generate a capital gain of $4.2 million ($4.5 million less $300,000 - the debt is given no effect for measuring gain). At a tax rate of 20% on the capital gain, the tax due would be $840,000. This is substantially higher than the $550,000 that would be due under the estate tax with stepped up basis even if the decedent's estate had been subject to the highest estate tax bracket. When the heirs in the stepped up basis example above sold the property for $4.5 million, their capital gain was $500,000 for an income tax liability of $100,000. The combined $550,000 estate tax and $100,000 capital gain tax are still less than the $840,000 capital gains tax due in this carryover basis example. The $840,000 amount would be even higher if the transaction involved recaptured depreciation allowances (which are taxed at 25%).

Capital gains taxes are imposed on gross amounts, while the estate tax is imposed on net amounts. Low basis property with debt encumbrances might thus actually be subject to greater tax burdens under carryover basis than those imposed by the estate tax. A low tax rate imposed on a large base can, depending on circumstances, yield a higher tax liability than a high rate tax imposed on a small base.

A Tax at Death?: Another anomaly might occur with carryover basis transfers of low basis, debt-encumbered property. This anomaly arises because of the operation of the income tax law, not the estate tax. Under current income tax law, the disposition of debt-encumbered, low basis property results in a gain to the transferor if the property is sold and both the property and the debt are conveyed to the purchaser or if the property and the debt are transferred as a gift. The rules of Section 1014 operate to require immediate recognition of gain in these circumstances.

If the estate tax were repealed, the income tax rules may affect the transfers of property from an estate to an heir. If the basis of the property were stepped up as in the example above, the recognition provisions of Section 1014 would generally not apply to the estate or heir. Current law taxes the net estate and then steps up the basis for the heir so that the debt is generally covered by the new basis. By contrast, carryover basis could trigger a taxable event at death. If the transferor is an estate transferring encumbered property to an heir, there may be an immediate tax due because of these income recognition rules of current law. The fact that the estate tax is repealed would not change the income tax outcome for these assets if carryover basis applied. Similar results (i.e., a tax at death) could occur when property is distributed from a trust to a beneficiary pursuant to a bequest.

Although the number of assets that would be debt-encumbered and low basis is relatively small compared with all assets, we urge Congress to correct this anomaly so that the inheritance of debt-encumbered, low basis property will not trigger an immediate income tax event. A stated goal of advocates of repeal is to assure that death is not a taxable event. Correction of this problem will assure that result.

Tax Attributes: Congress will need to make determinations about how to treat the various tax attributes that accompany both individuals and their property under the income tax. While the estate tax burden would be eliminated with repeal, the estate and its assets will still be subject to income tax rules. Congress will need to determine, for example, how to treat suspended losses under the passive loss rules under Section 469. Will the heir receive a basis adjustment for them, or will they disappear, or will they simply remain suspended losses?

Similarly, Congress will need to make determinations about the treatment of charitable contribution carryforwards for individuals and businesses, net operating loss carryovers for small businesses, investment interest carryforwards and capital loss carryovers. Whether these attributes continue to have separate identity and remain subject to various limited or unlimited time constraints, or whether they become adjustments to basis, administrators will have new burdens as carryover basis requires them to attempt to determine which assets produced which attributes. These burdens will be magnified in a part step up, part carryover scheme like the 2000 version of H.R. 8 or this year's S. 275..

Allocations of Basis: Part carryover, part step up models such as last year's H.R. 8 or the current S. 275 will create unique problems for administrators of estates that are larger than the allowable step-up amount. Administrators will need to allocate the step-up amount among assets. They will be required to make market predictions about the probable subsequent appreciation of the decedent's assets and the probable pattern of asset retention and disposition among the heirs so that they can make the most favorable allocations for the heirs. Even in the absence of an estate tax, it can be assumed that heirs will want to minimize their exposure to subsequent capital gains (and, if applicable, recapture) taxes. When the size of estates is only marginally less than the step up amount, administrators (or Congress) will need to devise both taxpayer and IRS recordkeeping rules that will allow subsequent heirs to verify either the stepped up or carryover basis of each asset.

Multiple Heirs/Multiple Generations of Heirs: Estate administrators of estates larger than any step-up amount will be particularly challenged in allocating the step-up amount among two or more heirs. In the absence of instructions from a decedent, how would an administrator choose to distribute cash, appreciated real estate, appreciated stock (whether these appreciated assets were high or low basis) and the residue of an IRA or 401(k) plan? Under stepped up basis, the determination of comparable value among these assets is relatively simple, because the value of each asset in the estate and thus to the heir is stepped up to its fair market value.

Under carryover basis, there would be no consistent method of valuing the assets for the assets for the heirs. To the extent that heirs disagreed with either the type of property received or its basis allocation and potential value, there could be increased controversy about disposition of estates. Heirs would likely prefer to receive either cash or high basis assets. Because of the potential tax exposure for low basis assets, those may become undesirable bequests. Moreover, there would be substantial differences in the yearly income tax benefits and liabilities to an heir of receiving these different types of assets.

Even more complicated problems arise for multiple heirs and multiple generations. Assume that a decedent had an estate with $8 million of stock in various companies, all acquired on different dates. The decedent leaves this stock to each of 3 children, and the allowable step-up amount is properly allocated. (This assumes that it is possible to make a basis determination and that the decedent had sufficient records on all of the stock with which to make the determination. Each of those 3 children holds the stock until his or her death, and each of them also has sufficient other assets for his or her own step up amount and some carryover basis assets, as well. Further, each of the 3 children has heirs.

How will the third generation heirs trace their basis from the first generation bequest? from the second generation? How will the records - which could cover a period of 40 or more years - be kept and retained? Who will bear the responsibility of keeping the records for the original bequest? How will the IRS know what assets from the original bequest received the step up and which received carryover basis? Will it be necessary to file returns, even for stepped up amounts? Will the IRS still have those records in a readable format after 40 or 50 years? Who will bear the burden of proof for establishing basis in multi-generation property? What if some of the assets become capital loss property?

Inevitably, the movement of property from generation to generation under carryover basis will compound the complexity of the taxpayer's obligations - even in the absence of an estate tax.

Potential Lock-in Effect: Over time, the basis of some assets will become very low relative to the appreciation and built-up gain in the assets, especially when the assets are carryover basis assets. This will be particularly true of depreciable assets, where, in theory, at least, the basis could be reduced to zero if it is not increased by improvements and renovations. While we have no empirical data to test our view, we believe that, over time, there could be an increasing lock-in effect as heirs find that the tax costs of selling low basis appreciated assets become increasingly disproportional. Historically, Congress has sought to eliminate the lock-in effect for appreciated assets. A long holding period for appreciated property with a low basis would surely have some lock in effect.

Impact on Surviving Spouses: Under current law, an unlimited marital deduction permits a spouse to leave all property to the surviving spouse without an estate tax consequence. The basis of the assets is stepped up to their fair market value. Then, when the second spouse dies, the estate tax is imposed on the value of the remaining assets. Under carryover basis, the marital deduction disappears, so any assets a surviving spouse will receive will be subject to the carryover basis rules. Even with a partial step up as under S. 275 (or last year's H.R. 8), a surviving spouse who needs cash or income could be forced to pay substantial taxes that would not be due under current law.

This will be particularly true in the case of an estate with a limited number of illiquid assets. For example, a spouse might inherit a going concern small business. The survivor may not wish or be competent to operate the business and may wish to derive her income from other, more stable sources such as fixed income funds or annuities. Under current law, if the spouse sold the business, he/she would incur only a capital gains tax on the difference between the fair market value of the business at the decedent's death and the sales price of the business. Under carryover basis, depending on the relationship of sales price, carryover basis amounts and stepped up basis amounts, the income tax/capital gains tax liability to the spouse at the time of sale might be significantly greater than any estate tax might have been.

Conclusion

The National Association of Realtors supports President Bush's original marriage penalty relief provision and is hopeful that any marriage penalty that the Committee crafts will apply equally to those who itemize their deductions and those who do not.

NAR also supports full estate tax repeal as found in the 2001 Dunn-Tanner version of H.R. 8. Despite our concerns from 2000 about carryover basis, we believe that its impact can be mitigated by assuring that only the most sophisticated taxpayers are subject to it. This mitigation can be accomplished by assuring that a step up amount at least as great as the $2.8 million in S. 275 is provided. NAR's Federal Taxation Committee and leadership have reviewed this issue carefully, and believe that full estate tax repeal is in the best interests of our members and the clients they serve.

Should you or your staff have questions related to these issues, please feel free to contact me at 202 383 1083 or at lgoold@realtors.org.

Sincerely,

Linda Goold
Tax Counsel