Uncertainty Over the Estate Tax

by  Michael P. Cannady

Eight years ago the federal estate tax was repealed for individuals dying in 2010, but it comes back in harsher terms for those dying after 2010. Most observers thought that the current Congress would undo the impending repeal and permanently or temporarily keep the tax at 2009 levels. However, that has not happened, which leaves estate planning in a confused state. And it doesn’t necessarily mean that taxes will be lower for heirs of a decedent dying in 2010. That’s because the estate tax repeal includes changes to the income tax basis rules for property acquired from a decedent.

Short History of Repeal

Prior to the 2001 Act, there was no estate tax on the first $675,000 of transfers at death, and the tax had a top rate of 55%. The 2001 Act increased the $675,000 exemption in stages after 2001; it rose to $3.5 million for individuals dying in 2009. The top estate tax rate was reduced in stages to 45% for transfers through 2009.

The 2001 Act provides for the complete repeal of the estate tax in 2010, but only for one year. Then, in January of 2011, the estate tax returns, with an exemption of $1 million and a top rate of 55%.

Basis Rules

While the current law does not impose an estate tax on decedents dying in 2010, the income tax basis rules for this one year are not at all favorable. Prior to 2010, when a person died, property included in his or her taxable estate received a step-up in basis. This means that if the decedent had purchased, for example, a piece of real estate for $80,000, and at the time of death it was worth $180,000, the estate’s basis in the real estate would be stepped-up to $180,000. Therefore, if the estate or the heirs sold the property for $180,000, there would be no capital gains tax on the sale. Under the 2010 law, however, the estate would receive a carry-over basis of $80,000, so when it sold the property for $180,000, there would be a taxable capital gain of $100,000.

Not only do these carry-over basis rules cause more capital gains taxes to be incurred, but they also cause a recordkeeping problem. Imagine if your parents had purchased a piece of real estate in 1952. To determine the basis of that property, you would have to figure out how much they paid for it, and then add to that the cost of any improvements which they made to the property over the years. This is difficult enough to do while your parents are alive, but if they have both passed, it can become impossible. The burden of proving the basis is on the taxpayer, so if you are unable to document the amount of the basis, you may be stuck with using a zero basis, which of course causes an increase in the amount of the capital gains tax.

Further Changes

Although Congress didn’t address these transfer tax issues before year end, it seems likely that something will be done in 2010. On Dec. 3, 2009, the House, by a vote of 225 to 200, approved a bill that would make permanent the law which was in effect for 2009. The Senate has not acted on this measure or on another bill under which the value of any estate above $7 million per couple or $3.5 million per individual would be taxed at a 45% rate.

Based upon statements made by legislators on both sides of the aisle, it does appear to be possible that some kind of compromise will be reached prior to October 1, 2010, the date on which the first estate tax returns for 2010 will be due. Such a compromise may involve the retroactive undoing of the estate tax repeal to the beginning of 2010. If this does happen, there will likely be lawsuits filed to test the constitutionality of such actions.

Keep in mind that if no action is taken, or if the action taken only provides for an extension of the 2009 law through 2010, there will be no vote needed in order to lower the exemption down to $1 million in 2011. That legislation is already in place. The only way to stop that from happening would be for congress to pass legislation providing for a higher exemption amount. President Obama, during the 2008 campaign, indicated that he was in favor of a $3.5 million exemption, so that is still possible.

Current Planning

What does all this mean to you? It is very difficult to say at this point. The only safe way to proceed may be to plan as if the exemption amount were $1 million. This means that if your estate, including retirement accounts and proceeds from life insurance, is in excess of $1 million, and you are married, you need to do some estate tax planning prior to the death of the first of you to die. You need to do this in order to take advantage of the exemptions of both spouses. If the first spouse dies before doing the necessary planning, the exemption of that spouse will likely be completely wasted.

If you are not married, the planning opportunities are not as numerous, but there are still a number of things you can do prior to your death, and the sooner you get started, the better.

(Article appeared in Adams Jones February 2010 Newsletter)