09/01
Taxpayers with sizable estates may be ecstatic that the new tax act repeals the federal estate tax, but many may not realize that repeal has a few complications that require some careful planning
First, full repeal doesn't actually occur until 2010. Second, the new act is set to "sunset," or expire, in 2011, and thus the estate tax would be repealed for only one full year unless Congress steps in before then. Third, even fewer taxpayers realize that if the estate tax is permanently repealed, a new tax is scheduled to take its place starting in 2010.
This new tax, called the modified carryover basis rule, is essentially a capital gains tax on inherited property such as stocks, real estate, collectibles or a family business. Why worry now about a tax that isn't scheduled to take effect until 2010? Read on.
Under the old estate tax rules, and continuing under the new tax act through 2009, a deceased's property remaining after any federal and state estate taxes are paid is generally passed on to heirs under the "stepped-up basis rule." This means the decedent's adjusted basis in the property is stepped up, or increased, to its market value on the date of the owner's death. (Or stepped down if the property has lost value.)
Here's an example. Father buys stock valued at $10 a share. At the time of his death, the stock is valued at $100 a share. His daughter inherits the stock with a step-up-in basis of $100. If she sells the stock immediately, no capital gains tax would be paid on the $90 in per-share gains. If she doesn't sell it until it reaches $120 a share, she'd pay capital gains only on the gain ($20) since her father's death. If the father had passed the stock to his daughter while he was alive, her basis would have been his original basis of $10 (including any adjustments) and she would have paid capital-gains tax on any gain above the $10.
The step-up rule has been used on the premise that inherited property has already been taxed in the owner's estate (except for the exemption amount) and it would be unfair to tax the gains again. But because of the scheduled repeal of the estate tax, Congress wanted to impose tax on capital gains that would otherwise go untaxed. So, it created the modified carryover basis rule, which essentially means the deceased's basis in the property carries over to the heir, instead of being stepped up at death. However, no tax is imposed on any gains until the property is actually sold. Thus, a family business could be passed on down several generations and none of the gain in the value of the business would be taxed, unless or until it is finally sold.
The new tax act provides some relief from the carryover rule. The executor of the decedent's estate can increase the property's basis by up to $1.3 million (but no higher than its fair market value) for property passed on to a non-spouse heir or heirs. The allocation is up to the executor. For example, the entire $1.3 million increase in basis could be allocated to the property going to one heir and none to another heir. Property left to a spouse can receive an additional $3 million increase in basis, for a total increase of $4.3 million.
Some property will not be eligible for this added basis. This includes property gifted or transferred to the decedent within three years before the decedent's death, as well as some foreign investments and other property."[CCH book, p. 121]
It may seem obvious now why you should care about the new carryover rule even though it won't go into effect until at least 2010. The key to meeting the new rule will be to have well-documented records on the basis of all inherited property. This becomes more difficult the longer the time to sale, or the more complicated the basis, particularly something like a family business passed down multiple generations. Commentators warn of future disputes with the IRS and attorneys who will charge extra fees because they have to spend extra time determining basis because of poor records.
So the advice is to determine an accurate, well-documented basis now, perhaps with professional help, and keep good records as a favor to your heirs.
This article was produced by the Consumer Affairs Dept. of The Financial Planning Association and provided to you courtesy of Nigel B. Taylor, CFP, Santa Monica, California. If you have any questions or concerns regarding this, or any other financial topic and are a resident of Southern California, please call me at 1-800-444-2237 (California residents only please), or click on the "MORE INFO" button to arrange for a free initial consultation in the comfort of your home or office.
