Estate tax lies in limbo, but for how long?

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In 2010, the federal estate tax died. That’s been good news for heirs of particularly large estates. For smaller estates, however, the lack of an estate tax and associated tax savings has been more problematic.

And everyone, regardless of an estate’s value, is in limbo while Congress works to resolve what to do about the estate tax for the rest of 2010 and in 2011, when it will be reinstated on much less favorable tax terms.

Phased-in phaseout

The end of the estate tax began in 2001 with the Economic Growth and Tax Relief Reconciliation Act. That year, gradual reductions of the estate tax rate began, along with increases in the value of an estate that would be exempt from taxes.

In 2009, estates of $3.5 million or less weren’t taxed; those worth more than that faced a 45 percent rate.

When Jan. 1, 2010, arrived, the estate tax disappeared. But the 2001 act that made it possible also included a provision that a stricter estate tax would return in 2011.

If no legislative action is taken, next year a federal estate tax of 55 percent will be assessed on estates of more than $1 million.

Basis problems in 2010

For very large estates, the absence of a federal estate tax generally is a boon.

However, some heirs might not be as thrilled. If beneficiaries want to sell some property they inherited, they could be facing substantial capital gains taxes because when the estate tax died, so did the option to step up basis.

The stepped-up basis option had allowed heirs to inherit the current value of the property. This, in turn, helped produce a lower tax bill when the item was sold.

When the loss of stepped-up basis came to light, Congress authorized the IRS to exempt the first $1.3 million in capital gains and an additional $3 million in gains for a spouse. But anything over those thresholds will be subject to taxes using the original basis valuation method.

A choice of estate tax laws

Even with the exemption, though, some estate heirs might find they would have been in a better tax situation under the 2009 law.

There is discussion on Capitol Hill and with the Obama administration to allow executors to choose whether to handle the taxes of an estate under the 2009 or 2010 laws.

Although there are administrative issues to work out before any such filing option could be put in place, this suggestion is gaining support.

Not only would the choice make taxpayers happy, not a small concern in an election year, it would eliminate any legal challenge that would be likely if Congress tried to make a new estate tax law for 2010 retroactive to the beginning of the year.

2011 outlook

As for what to do about the estate tax in 2011, the consensus in the U.S. House is that the 2009 law — a 45 percent rate on estates of more than $3.5 million — should be reinstated. That is the level proposed in the president’s budget.

However, some senators would like the exemption amount increased to $5 million and the tax rate on larger estates dropped to the 30 percent to 40 percent range.

And all of Capitol Hill would like to see whatever version is agreed upon to be permanent. The likelihood of that, however, will depend on how far apart the sides are as the end of 2010 nears.

In the short term, a one-year extension of the estate tax at the 2009 law levels might be used to buy time so that Congress can continue this debate.