Avoiding Traps in the Expired Estate Tax

The expiration of the estate tax is not good news for every-one. A new tax replaced the estate tax, and some estates, mostly modest estates, will pay more in the new tax than they would under the old estate tax. People who previously weren’t worried about estate taxes have to worry about the new tax.

The new tax is known as carryover basis. Under the estate tax, capital gains that accrued during your lifetime were not taxed to the next generation. When assets were inherited, the new owners increased the tax basis to the current fair market value. They could sell the assets immediately and owe no capital gains taxes, because the sale price minus the basis equaled zero.

The law that allowed the estate tax to expire for 2010 also created the carryover basis. Heirs who inherit assets under current law also inherit the tax basis the previous owner had in the assets. The tax basis usually is the original cost of property. When property is sold, the gain or loss is the amount realized from the sale minus the tax basis. When heirs sell inherited assets under the carryover basis law, the heirs will owe capital gains taxes on whatever appreciation accrued during your lifetime. This is the same rule that always has applied to gifts of property. For 2010 it applies to inheritances as well.

There are a couple of exceptions to carryover basis. The first $1.3 million of appreciation is exempt from the carryover basis. Plus, an additional $3 million in appreciation on assets inherited by a surviving spouse are exempt.

The carryover basis will result in higher taxes on some estates than the estate tax would have, and modest estates are more likely to be hit with the higher taxes than large estates.

Consider a $3 million estate that an unmarried Max Profits leaves to his children. Under the 2009 law, there would have been no estate taxes. Under the law in effect in early 2010, however, the first $1.5 million of assets are exempt from the carryover basis, but the remaining $1.5 million are not.

Suppose Max owned $500,000 shares of stock he bought years ago for $50,000. If his heirs sell the stock, they will have capital gains of $450,000 with a tax bill of $67,500. So, under the “no estate tax” regime the heirs have less after-tax wealth than they did under the estate tax.

The carryover basis changes planning, at least while it is in effect. In the past, spouses were advised to equalize the values of their estates. That allowed them to take full advantage of their lifetime estate and gift tax exemptions. Under the carryover basis rule, spouses don’t care about the relative values of their estates. They want to equalize the unrealized gains in their estates. They want to be sure each spouse takes full advantage of the $3 million carryover basis exemption, so capital gains taxes are minimized on assets left to each other. Of course, once the estate tax is reinstated if the old basis rules also return, then you’ll want to go back to equalizing the value of assets between spouses.

Fortunately, gifts between spouses are exempt from gift taxes. Assets can be transferred back and forth without tax cost. There may be lawyer’s fees and other costs, but there won’t be gift taxes.

Another important action under the carryover basis rule is you’ll need to have good records of the tax basis of all your assets. If your heirs can’t prove the basis of the assets they inherit, they have to assume the basis was zero and pay capital gains taxes on the full value of the assets when they are sold.

Under current rules, the best steps you can take for your heirs are to organize records proving the tax basis of your assets and let your executor know where the records are. You’ll need to prove the basis of your assets if you might sell the assets during your lifetime anyway, so this is work you should do anyway.

The law allows an estate executor to designate which assets qualify for the exemption from the carryover basis rule and which are not. This can result in some complicated decisions.

The initial instinct is to exempt those assets with the most appreciation. But it would be wasteful to assign the exemption to an asset that is likely to remain in the family’s hands and not be sold for years. Why assign the exemption to an heirloom, collectible, retreat, or family business that isn’t likely to be sold? It might be better to assign the exemption to investments and other assets that are likely to be sold within a few years.

The heirs who inherit the assets also are a factor in assigning the exemption. The executor probably wants to equalize the after-tax value of the assets received by each heir if the deceased’s goal was equal inheritances.

That requires an examination of the tax situations of each heir. The executor should examine ways capital gains taxes could be deferred or avoided on some assets. The beneficiary who inherits each asset also is a factor. For example, an heir who inherits investment real estate could exchange it for other investment real estate instead of selling it. A beneficiary in a low tax bracket or who has a lot of capital loss carryovers may be able to sell the assets at little or no tax cost, while other heirs would owe the maximum 15% long-term capital gains rate plus state capital gains taxes. Because of the individual factors, some heirs may not need to increase the basis as much as other beneficiaries.

Some estate planners recommend giving special attention to the appointment of an executor now. You need someone who is able to make decisions about which assets are exempt from the carryover basis and which are not. Alternatively, your executor can rely on the advice of a good tax advisor who can work through the options.

Many people also don’t realize that the gift tax remains. You continue to have a $1 million lifetime gift tax exemption, and the annual gift tax exclusion (currently $13,000) remains. But gifts above those amounts are taxed, and you need to file a gift tax return for gifts above the annual exclusion. The good news is the gift tax rate is reduced to 35% from 45%, at least for 2010.

Remember, these are the rules in effect only for 2010. Congressional leaders say they plan to reinstate the estate tax during 2010. If they don’t, in 2011 the estate tax that existed in 2001 is reinstated.

No-estate-tax doesn’t mean tax planning is no longer part of estate planning. In fact, until some form of estate tax is reinstated tax planning is important for more estates than when there was an estate tax in 2009. Those estates with the most to worry about are mid-range estates in the $1.3 million to $4.5 million range that didn’t worry about taxes before.