American Taxpayers Relief Act.
FINALLY! The first temporary rules were passed by Congress in 2001. Twelve years later and two major tax changes in between, it appears we FINALLY have permanent estate tax rules. Software companies, estate lawyers and financial planners should all be breathing easier after Congress passed the American Taxpayers Relief Act.
Here’s a brief summary of the federal estate tax laws included in the Act. The only change from the current federal estate tax rules that went into effect in 2011 is an increase in the tax rate.
1. The federal estate tax exemption allowance stays at $5 million.
2. Portability stays. Portability gives married couples the ability to exempt $10 million of assets from any federal estate taxes by filing a Deceased Spouse Unused Exemption Allowance form when the first spouse dies.
3. The estate tax rate on estates exceeding the $5 million estate tax exemption allowance will be 40%, a change from the current 35% tax rate.
On January 1, 2010, the rules about taxing inherited asets changed.
To understand why dying in the year 2010 is different from dying in any other year, you must understand how inherited assets are taxed.
- Unless someone dies in 2010, all of their heirs will inherit property with a “stepped-up basis.” Stepped-up basis is an Internal Revenue Service term describing the tax basis of inherited property as equal to the fair market value of property on the date of death. When inherited property is sold, the beneficiary uses the stepped-up basis to calculate and report capital gains. If the sales price exceeds the stepped-up basis, the beneficiary reports the profit as a capital gain on his or her tax return and pays the necessary capital gains taxes.
- Example: Sue inherited a house from her mother, who bought the house fifty years ago for $25,000. On the day her mother died, the house had a fair market value of $500,000. Sue sold the house six months later for $525,000. Sue reported a capital gain of $25,000, the difference between the stepped-up basis and the sales price.
- Unless you die in 2010, the decedent’s estate is required to pay estate taxes if the fair market value of all the property on the date of death exceeds the federal estate personal tax exemption allowance for that year. If estate taxes are due, the estate representative pays the estate tax and then distributes the remaining assets to the heirs.
- A surviving spouse receives an unlimited federal estate tax marital exemption. No federal estate taxes are due, even if the fair market value of the inherited property exceeds the federal estate tax personal exemption allowance. Any inherited property sold during the lifetime of the surviving spouse uses a stepped-up basis to calculate capital gains.
- Estate planning documents may include a reference to the federal estate tax personal exemption allowance as a way of reducing estate taxes or allocating assets between different trusts and beneficiaries. They may determine how much a surviving spouse or child inherits.
- The federal estate tax rates for the year determine how much tax is due.
What will be different if someone dies in the year 2010?
In 2001, Congress passed a bill known as The Economic Growth and Tax Reconciliation Act of 2001. Section V of this bill specifies how inherited assets are taxed between the years 2002 and 2011.
For the years 2002 through 2009, the Act changed the amount of the federal estate tax exemption allowance as well as the federal estate tax rate.
- The federal estate tax exemption allowance increased from $1 million to $3.5 million.
- The federal estate tax rate decreased from 55% to 45%.
The Act resulted in fewer estates being subject to the estate tax and decreased the amount of taxes due for those estates that were subject to an estate tax. Most important, the Act did not change the fundamental way in how inherited assets are taxed.
If you die in 2010, there is no estate tax. There is no federal estate tax exemption allowance and no federal estate tax rate schedule. You could have an estate worth hundreds of millions of dollars and no estate tax is due. The elimination of the estate tax does not mean there is no tax on inherited assets. The Act requires the beneficiaries, not the estate representative, to calculate and pay taxes on inherited property using either a stepped-up basis or a carryover basis.
- The estate representative must calculate and document the carryover basis of inherited property. The term “carryover basis” means the tax basis is the original cost paid for the property. The greater the increase in value of the property between the date of purchase and the date the beneficiary sells inherited property, the more taxes a beneficiary pays.
- Example. Sue inherited a house from her mother, who bought the house 50 years ago for $25,000. On the day her mother died, the property had a fair market value of $500,000. Sue sold the house six months later for $525,000. Sue reported a capital gain of $500,000, the difference between the carryover basis (the original price of the property) and the sales price.
- An estate representative must also calculate the stepped-up basis of the decedent’s property.
- The estate representative can only distribute a limited amount of assets using a stepped-up basis.
- $1.3 million can be distributed to beneficiaries with a stepped-up tax basis.
- $3 million of assets can be distributed to a surviving spouse with a stepped-up tax basis.
- All other inherited property must be distributed to beneficiaries using the carryover tax basis.
- All beneficiaries must calculate and pay capital gains when they sell an inherited asset. The estate representative will provide documentation the beneficiary can use to document on their tax return whether capital gains are calculated using a stepped-up basis or a carryover basis.
If you die in 2011 or any year thereafter, the Economic Growth and Tax Reconciliation Act of 2001 is repealed. The rules about estate taxes and the tax basis of inherited property revert back to the rules in existence in 2001. Heirs inherit property and calculate capital gains using the stepped-up basis. The federal estate exemption allowance reverts back to $1 million and the maximum estate tax rate reverts back to 55%.
Because the rules on the taxation of inherited assets are so fundamentally different for someone who dies in 2010, no one thought Congress would allow the existing Economic Growth and Reconciliation Act of 2001 to remain in effect. In December, the House voted to provide a permanent federal estate tax exemption of $3.5M and a maximum federal estate tax rate of 45%, effective January 1, 2010. The Senate could not agree on what the amount of the federal estate tax exemption allowance and the rate of the estate tax should be and did nothing. Senator Backus was quoted as saying it was not a priority within the Senate to change the existing 2001 legislation, but has implied he will make it a priority in 2010.
What does all of this mean if you die in 2010?
What began as a debate on how much wealth someone could pass on to their heirs free of estate taxes has evolved into a mess for everyone who dies in 2010, not just the wealthy.
- Good records just became more important. In order to calculate the carryover basis for inherited property, the estate representative will need to know the original cost of all of the property. Just imagine documenting stock splits or the cost of a home bought fifty years ago.
- Existing estate planning documents that make choices based upon the amount of the federal estate personal tax exemption allowance won’t work. There is no federal estate tax exemption allowance in 2010. You may accidentally disinherit a spouse or your children!
- If the value of your estate exceeds $1.3 million, your estate representative will determine who inherits assets using a stepped-up basis or a carryover basis. The unlimited marital tax exemption allowance does not exist for surviving spouses. A surviving spouse may pay more in capital gain taxes during their lifetime if their spouse dies in 2010 than they would pay if he or she died in any other year.
- It will be a tough year for estate representatives. They must determine the intent of existing planning documents or existing intestate laws versus the need to follow the rules for taxing inherited assets in 2010. It will be a good year for estate planning litigators.
The Senate has stated it intends to pass new legislation with the intent to make the legislation retroactive to January 1, 2010. Every day that passes without some type of resolution compounds the problem. Do we need to change our estate planning documents? What happens with software or web sites providing information about estate taxes? Can we die retroactively?
If you know you won’t die in the year 2010, you may not want to call your financial planner or your estate planning lawyer. Otherwise, it may be wise to call and get their advice and input on how to deal with the mess Congress has created for everyone.