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Estate tax basis basics

By Kay Bell ·
Friday, July 23, 2010
Posted: 4 pm ET

My blog item about what's up with the estate tax prompted some questions from Bankrate reader Jay.

First, Jay would appreciate if I would elaborate a bit on the change in the stepped-up basis rule that is affecting some people who've inherited estates. He also wonders whether there are any figures on the taxes gained by the basis issue.

Great questions, as they point out not only the practical implications of any tax law changes, but also the fact that tax legislation in particular is rife with unintended consequences.

With the enactment in 2001 of the Economic Growth and Tax Relief Reconciliation Act, the estate tax was repealed for the 2010 tax year. To get to no estate tax status, the tax rate was reduced and the exemption amount for estates increased for the years leading up to 2010. Before it disappeared, estates of $3.5 million or less weren't taxed; those worth more than that faced a 45-percent rate.

Estate tax is a complicated law -- lawyers who specialize in it continue to get rich -- and changes were made to various provisions during the phase out period. The biggest one for the 2010 death of the estate tax is the provision Jay mentioned: how to deal with inherited basis.

Basis is, in simplest terms, the value of an item. You need it to figure your profit, upon which you'll owe tax, when you sell the item.

Under the most-recent incarnation of the estate tax, folks who inherited property were able to take stepped-up basis. If Uncle Joe left you 100 shares of XYZ stock and it was worth $50 per share on the day he died, your basis in the asset was stepped up to $5,000.

Without that step-up in basis, you'd inherit the stock along with Uncle Joe's original basis. Let's say Joe bought those 100 shares for $10 each, making his -- and now your -- basis $1,000.

If you want to share all of your inherited XYZ stock, which now is selling for $70 a share, you'd want stepped-up instead of original basis. When you get your $7,000 from the sale ($70 x 100) and subtract Joe's original $1,000 basis, you'll owe the IRS capital gains taxes on $6,000. But if you get to use stepped-up basis, you subtract $5,000 from $7,000 and only owe taxes on a profit of $2,000.

So while the absence of tax this year is great for estates left by Dan Duncan and George Steinbrenner and others of that ilk, for the heirs of the vast majority of estates, no estate tax could be costly.

Of course, as I noted before, it's still a complicated law and my example is very basic. There are some additional provisions to provide relief -- a $1.3 million threshold -- for immediately family, such as spouses and children.

But many folks could end up paying more taxes in this year of no estate tax than they would have if the tax had been in effect. This was one of those unexpected consequences, at least on the part of people not involved in the drafting of the estate tax expiration law.

As for Joe's other question about the money that Uncle Sam might be making in 2010 on folks who sell assets using original basis price, there's no estimate yet.

We've been without an estate tax since Jan. 1 and estates have nine months after date of death to file; most executors are waiting until the final deadline to see what Congress will do. That means the earliest filings will be in September and it will be some time after that before heirs will get their bequests to do with what they wish and the IRS gets any money based on those actions.

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