Explanations Item 1.

Basis of Property Acquired from a Decedent Ignore yesterdays comments I made about changes regarding the basis of property acquired from a decedent. Do problem 2(f) as written. Make sure to omit from the second paragraph on 97 to paragraph C on 98 (and the other omissions indicated on Chapter 5, syllabus paragraph 2). At the bottom of h/o 21, I wrote: Executors for estates of decedents who died in 2010 did not know whether there would be an estate tax for 2010 or not. By the time Congress finally passed the bill in December 2010, it was too late to reenact the estate tax for 2010. Congress gave executors of 2010 decedents a choice. They can elect to have the estate taxed at the 2011 35% rate with a $5 million exemption, in which case the heirs will get a stepped-up basis for inherited assets [emphasis newly added]. Alternatively, they can elect to pay no estate tax. However, the heirs of these estates will get a carryover basis for inherited basis, with some adjustments. This paragraph is correct as written. You will not be responsible for property inherited from decedents who died in 2010, nor any estate tax computations. For income tax purposes, the basis of property acquired from decedents who die in 2011 and 2012 is the fair market value on the date of death, as described in the casebook. The reduced estate tax rates, the higher lifetime exemption and the step-up basis provisions are all scheduled to expire on December 31, 2012.

Item 2. Clarification of the answer to Chapter 2, syllabus problem 7 Problem 7. A painter bought two boxes of photographs for $45 at a yard sale in 2001. In 2010, he discovered the boxes contained 65 glass negatives made by American nature photographer Ansel Adams worth an estimated $200 million. If he sells the negatives for $200 million in 2011, what are his tax consequences in 2000, 2010 and 2011? Answer If the painter bought the box of photographs and the negatives, when he discovered the negatives were worth $200 million in 2010, there would be no income in 2010. The negatives are not treasure trove; he simply made a bargain purchase. When he discovered the negatives were worth $200 million, it was simply unrealized appreciation. When he sells the negatives for $200 million in 2011, he will report a gain of $200 million, minus the portion of the $45 purchase price that would be allocated to the negatives. However, if the painter thought he was buying just the photographs and discovered the negatives in 2010 hidden under the paintings, the negatives would be treasure trove. He would report $200 million of income in 2010 and his basis in the negatives would be $200 million, the tax cost basis. He would have no income in 2011 if he sold them for $200 million.

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Item 3. Refinancing a Mortgage Loan In Chapter 4, casebook problem 2, transaction (c), Maggie refinanced the property to obtain a lower rate and take out some cash. What she really did was refinance her loan with a new loan at a lower interest rate. Some students may not understand the consequences of refinancing a mortgage loan. The following example should help you understand the refinancing transaction and the tax consequences. Example In 2001, The Lavins bought a condo for $300,000, paying $60,000 down and obtaining a $240,000 30-year mortgage loan at an interest rate of 8%. The basis of the condo is $300,000. The monthly mortgage payment (excluding escrows) is $1,761.03. By 2005, the condo has increased in value to $420,000 and mortgage interest rates had fallen to 5%. (The interest rate on 30-year mortgage loans is currently about 4.28%) The balance of their first mortgage loan is now $236,000, because they have gradually reduced the principal by each mortgage payment. Mortgage lenders typically would loan 80% of the fair market value of the property, so they obtain a new loan for $336,000 at an interest rate of 4.5%. The monthly mortgage payment is $1,803.72, only $42.69 more per month than the first loan. $236,000 of the $336,000 proceeds of the new loan is used to pay the balance of the old loan. The $100,000 balance of the loan goes into their pockets to use for any purpose. The $100,000 is not income because they are simply borrowing more money. The refinancing transaction does not affect the basis of the condo unless they make permanent improvements. Homeowners often refinanced their mortgage loans several times with higher and higher loan amounts because the value of their homes kept increasing and mortgage interest rates were falling. (See the graph of housing prices on the next page.) As shown in the example, a homeowner could withdraw $100,000 tax-free from the equity in his home and because of lower interest rates, the monthly mortgage payment increased by a relatively small $42.69. Of course the homeowner would receive less proceeds when the property was sold because of the additional loans. Besides refinancing their mortgage loans, homeowners often obtained home equity lines of credit, which are second mortgage loans on the home. Housing prices began to decline in 2006, the decline accelerated, and hasnt ended yet. The value of tens of thousand of home homes have declined below the balances owed on the mortgage loans. Some homeowners simply gave the house keys to the bank because they didnt want to keep paying on a loan that was more than the value of the home. (The lenders seldom seek to recover the balance of the mortgage loan from the defaulting borrower, although the borrower is legally liable for the deficiency.) Others lost their jobs in the weak economy and couldnt afford to make the mortgage payments, so their homes were foreclosed.

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