Most estate planners never expected Congress to let federal estate tax expire. And when it did, most expected Congress to quickly enact new estate tax legislation, possibly making it retroactive to January 1.
As of today, Congress has yet to act, leaving the estate planning world in a continued state of turmoil.
The Death of the Estate Tax
Last year, only estates valued in excess of $3.5 million were subject to an estate tax of up to 45 percent. As a result, only about 5,500 Americans died having estates large enough to incur any estate tax liability. The vast majority of Americans who died in 2009 were not affected by estate tax at all.
Congress was expected to extend the federal estate tax exemption amounts and tax rate last year, but did not. Because of Congress’ inaction, the federal estate tax was temporarily repealed on December 31, 2009, but will be reinstated in 2011 with an exemption amount of only $1 million and a tax rate of up to 55 percent.
While the temporary repeal of the estate tax appears to be a cause for celebration, with it came the expiration of the IRS provision for date of death valuations. The consequence has been increased tax liability for Americans who ordinarily would not have been affected by estate tax.
The step-up cost basis
The cost basis is cost of acquiring an asset. Normally, when assets are sold, capital gains taxes accrue on the difference between the sales proceeds and the cost basis.
Before January 1, 2010, the cost basis was “stepped-up” to the fair market value on the deceased person’s date of death, and applied to an unlimited amount of assets. So when beneficiaries sold an inherited asset, they were not required to pay capital gains taxes on any appreciation that occurred before the date of death. Only the difference between the sales proceeds and the date of death value was taxed.
The step-up basis provided enormous tax savings for appreciated assets. For example, if someone died in 2009 leaving a home he purchased for $100,000 in 1980, and the home was worth $2 million when he died, his beneficiaries could sell the home for $2 million without incurring capital gains tax liability.
The carry-over basis
But with the temporary repeal of the estate tax, this changed. In 2010, the cost basis of property acquired by a beneficiary is equal to the lesser of the deceased person’s basis, or the property’s fair market value on the date of death.
Each estate can exempt $1.3 million of appreciation ($4.3 million for a surviving spouse) from this carry-over basis rule. But beneficiaries will be required to pay capital gains taxes on all other appreciated assets. This means that beneficiaries of the same home could be responsible for paying capital gains taxes on $1.9 million when they sell it.
So while the majority of estates will still escape taxation, it is estimated that tens of thousands more individuals will be faced with an increased tax burden.
Carry-over basis creates complications
The executor of an estate will be required to choose which assets should receive the step-up. All other assets will retain the deceased person’s cost basis and be subject to capital gains taxes when sold. As a result, beneficiaries will need to know the deceased person’s cost basis. This can be very difficult if the assets have been held a long time and detailed records weren’t kept.
Additionally, once assets are inherited, the need to keep records that distinguish between assets that received a step-up in basis and those that did not will complicate enforcement efforts. The complexities will only multiply as more generations pass on their estates.
In 1976, Congress enacted a carry-over basis provision, but it proved to be too complex. Congress ended up repealing that law before it took effect because of the enormous administrative burdens it caused for estates, heirs and the Treasury Department.
Let’s hope Congress repeals it again.