Some advocates of a permanent estate tax repeal might want to consider this warning: Be careful what you wish for.

As is often the case in tax-law changes, when some taxpayers win, others lose. That will be the case in 2010 when, under current law, the estate tax disappears for that year only. Ironically, that same year some heirs will find they owe more in taxes than they would if the tax had remained in place.

“It’s a tricky area,” says Stephen Trenholm, a CPA and tax manager at Rucci, Bardaro & Barrett in Boston. For some taxpayers, he says, the 2010 change is not tax relief, but “actually a tax increase in disguise.”

How can a tax that no longer exists produce bigger tax bills? Because an accompanying change to the valuation system of inherited assets, known as stepped-up basis, goes into effect when the estate tax disappears.

Current law provides a basis tax break for inherited property. Heirs can “step up” the basis of any property they receive to its fair market value on the day that the original owner died.

But in 2010, heirs must assume, or carry over, the departed’s basis in the property. This, of course, has tax ramifications. Since some property will have greatly appreciated over the years, lawmakers decided to give heirs a bit of basis consideration: $1.3 million of inherited property receives a step-up in basis, with surviving spouses getting an additional $3 million, bringing the basis total for a widow or widower to $4.3 million.

While that seems substantial, some individuals, particularly nonspousal heirs, will find the step-up change will create capital gains issues they didn’t have to deal with while the estate tax was collected.

And if the estate tax is permanently repealed, the basis problem will live on.

Tax cost of selling inherited assets
Year of death Amount of property exempt from the estate tax Basis of inherited property used

to calculate capital gains tax

2002 and 2003 $1 million Full step-up in basis
2004 and 2005 $1.5 million Full step-up in basis
2006, 2007, 2008 $2 million Full step-up in basis
2009 $3.5 million Full step-up in basis
2010 Tax repealed Carry-over basis, with additional step-up basis of up to $1.3 million for nonspousal heirs; property left to husband or wife allowed additional $3 million step-up (total basis of $4.3 million).
2011 $1 million Full step-up in basis

Uneven estate tax implications

The new estate-tax repeal and new basis rules won’t affect every estate transferred in 2010. But one congressional study estimates that more than 71,000 estates will face at least increased tax-filing and compliance issues because of the change in law, with many of those individuals also actually seeing larger bills than they would under current law.

The number of estates hurt by the change, according to the report prepared by the Democratic staff of the House Ways and Means Committee, is nine times greater than the number of heirs who will benefit from repeal.

Many of the heirs who will be hit the hardest when the tax disappears in 2010 are likely to be children who lose their lone surviving parent that year and inherit a substantial amount of property.

They may be surprised at the total value of the assets they inherit. If their parents were diligent savers and held onto to the houses they bought when the children were young, the appreciation can be quite impressive. It might not put them into the same league as Bill Gates or Warren Buffett, but it’s not an inconsequential sum.

These heirs — let’s call them the “slightly wealthy” — might also be surprised by the tax trouble they encounter when they try to sell some of their new wealth, since they will be facing the stricter stepped-up-basis rules.

And they undoubtedly will be shocked to discover that, while the estate tax and inherited property basis are causing them unforeseen IRS issues, individuals who inherit substantially larger amounts in 2010 will be reaping greater rewards from the estate tax repeal.

The new wealth gap

The window of wealth that’s likely to produce the biggest estate headaches, according to the analysis from the minority staff at Ways and Means Committee, is $1.3 million to $5 million in inherited property.

To see how the new, slightly wealthy will be hurt if they inherit in the year the estate tax is repealed, you have to look at current tax laws governing estates and capital gains.

When you sell property, to determine any potential tax, you must figure your gain by subtracting what the asset was worth initially, known as its basis, from the sales price you get. For example, if you paid $10,000 for a stock and then sold it for $25,000, you would owe tax on the $15,000 gain. At the typical 15-percent, long-term capital gains rate, that’s $2,250.

In any year before 2010, recipients of inherited property get a step-up in basis no matter how much it’s worth. “Right now this year, if a person dies with $2 million worth of stock that went up 10 times in value, it would be completely exempt and the heir could turn around and sell it without any tax because of step-up basis,” says William Massey, senior tax analyst at RIA, a Thomson business and provider of tax information and software to tax professionals.

Basically, the step-up basis rule means you don’t have to pay for your parent’s investing acumen that grew $200,000 into $2 million. That one provision saves you from a tax bill of $270,000 on $1.8 million in profit.

Family home could mean inherited tax costs

The greater the appreciation of an inherited asset, the more valuable the step-up option becomes. And nowhere, especially in recent years, has appreciation been greater than in real estate.

In many cases, an estate’s largest asset is the family home. The children who are bequeathed the house often decide to sell the property so they can have cash to use for other needs, such as a child’s educational costs. But if the home has skyrocketed in value over the many years their late parents lived there, then the $1.3 million cap applied in 2010 could mean they’ll face a sky-high tax bill on its sale proceeds.

“The majority of people look at that $1.3 million and it seems like a fair amount of money,” says Trenholm. “But with today’s real estate, it’s not unusual for a lot of people to have assets that reach that amount.”

Trenholm uses this example, which he notes is simplistic for illustration purposes, to make his point:

Assume a child’s widowed mother passes away. The child is her only heir and her home, worth $2 million, is the only asset in her estate. Under the current rules, her estate, the house, is not subject to federal estate tax since up to $2 million is exempt (the amount increases to $3.5 million in 2009). In addition, the child can sell the home for its full, stepped-up market value and owe no taxes on the proceeds.

Fast forward to 2010. The widow dies that year and leaves the same $2 million home to her only child. Since the estate tax is repealed, there is no worry in that area. However, if the child decides to sell the inherited home, the basis issue looms large. Rather than being able to use the $2 million market value as basis, the heir can only claim a basis of $1.3 million. That means a sale price of $2 million will leave the child with $700,000 in profit on which taxes are due, or a tax bill of $105,000.

So this heir would be better off if the transfer occurs before 2010, while the estate tax is still in place. Once it expires in 2010, and years thereafter if Congress repeals it altogether, this person and those in a similar situation will be dealing with the no-estate tax/larger-capital-gains tax predicament.

Property step-up dilemmas

Massey says the loss of full stepped-up basis is also going to require those receiving bequests, as well as the executors who manage the distributions, to more carefully consider what the heirs plan to do with the property.

This potential problem arises when estates: a) contain a combination of appreciated assets, such as real estate and stock holdings, and b) involve families with multiple heirs. For example:

Potential problem:
  • The oldest child is left the $3 million family home, with a carry-over basis of $300,000.
  • The middle child gets Stock ABC, transferred with a basis of $500,000 and now worth $2 million.
  • The youngest child gets Stock XYZ and Mom’s basis of $100,000, although the stock is now worth $1.5 million.

With no estate tax, the combined $6.5 million estate owes Uncle Sam nothing. But the children, if they want to sell their inherited property, will each face a tax bill on the gain. The $1.3 million step-up provision could help at least one of them dramatically lower that tax cost.

Which asset, and heir, should get the benefit of the $1.3 million step-up? Or should it be divided among them? And who decides?

“The executor is going to have to figure out how to allocate that $1.3 million of basis,” says Massey, “to try to determine which assets the heirs are going to likely sell and add the basis increase to those assets so they can make use of that increase.”

At the very least, says Trenholm, “without the step-up in basis as it exists, there’s going to be an awful lot of extra record keeping.”

Why the really rich aren’t bothered

If estate tax opponents do ultimately prevail in permanently ending the tax, won’t all heirs face the same step-up- versus carry-over-basis issue, regardless of how large their inheritances?

Yes, but the practical effects can be markedly different for the very wealthy and the slightly wealthy.

“More people of the middle to upper-middle class, rather than the very rich, will be affected,” says Trenholm. “Mom and Dad worked very hard and kept the house very nice and wanted to see that home pass throughout generations. But the kids find it’s too much to handle. The house is too large, and they want to use it to fund their children’s educations.”

If the “very nice” house is worth more than $1.3 million, not unusual in some real estate markets, the heirs will face a tax bill when they sell.

The very rich, on the other hand, tend to hold on to inherited property. They are not as likely to need to convert an inherited asset to cash, so they avoid the step-up problem and reap substantial benefits in terms of estate tax savings, says Massey.

And where very rich heirs do sell an asset, he says, they generally have enough money from other sources to cover the tax cost.

Both Massey and Trenholm say that for most people, the optimal estate tax modification would be to keep the tax, but increase the exemption level and maintain the current step-up rules.

That’s the plan under the bill passed by the House of Representatives in late June. The measure, however, is stalled in the Senate. And some lawmakers on both sides of Capitol Hill are adamant that they will only accept full repeal of the estate tax.

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