Beginning January 1, 2010, the 45% estate tax on estates over $3.5 million for individuals or $7 million for married couples is eliminated (temporarily). However, the estate tax returns in 2011 — at a higher 55% tax rate and applied to even smaller estates.
NO ESTATE TAXES IN 2010 BUT HIGHER CAPITAL GAIN TAX CONSEQUENCES
Along with the elimination of estate taxes in 2010, the familiar “step-up” in basis on property owned by a decedent at death is now limited to $1.3 million, which may be allocated among the decedent’s assets. Given the limited basis step-up, the heirs of a decedent dying in 2010 might owe capital gain taxes based upon the decedent’s adjusted basis at the time of the decedent’s death. If the heir cannot establish evidence of that basis, the IRS dictates that the heir’s basis is zero. In this regard, things might get more challenging as heirs will have to prove the basis of assets which can be very difficult for many heirs, as stock splits, mergers and dividends could render tracking a nightmare. Essentially, this may leave many heirs of estates over $1.3 million in 2010 in the unfortunate position of paying more in capital gain taxes. According to the Reuters article, “Estate Tax Seen Bringing Chaos,” up to 70,000 heirs could face higher taxes, despite the elimination of the estate tax in 2010.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (“2001 Act”) temporarily repealed the estate tax and generation-skipping transfer tax for estates of individuals dying in 2010. However, the current transfer tax rules are in a state of flux as a result of changes made by the 2001 Act that have been gradually implemented. The 2001 Act contained a so-called “sunset rule”, under which the pre-2001 rules return after 2010, unless Congress provides otherwise. The 2001 Act also changed the unified system so that the gift tax exemption amount remained at $1 million for all years after 2001. Unlike the estate tax, the gift tax is not repealed during 2010. However, under the “sunset rule,” both the estate and the gift tax exemptions will be $1 million. In 2010, there is no estate tax and the top gift tax rate is 35%. The top estate and gift tax rates revert to 55% in 2011.
POSSIBLE WINNERS IN 2010
The heirs of individuals dying in 2010 with very large estates will save a substantial amount of estate tax. While they may also be exposed to some capital gain taxes under the modified carryover basis regime, the estate tax savings could more than offset the increased income tax costs.
POSSIBLE LOSERS IN 2010
Heirs of many smaller estates could come out worse as the step-up in basis is removed. While these individuals won’t face estate tax costs, they could face significantly higher income and capital gain tax costs.
Whether a winner or a loser, the potential to defer capital gain taxes with a 1031 exchange remains a viable option for heirs inheriting appreciated property under the current tax regime.
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