While there is much debate in Congress over the possible changes to the tax code regarding income taxes, the push may end up renewing debate over a death tax rebate for 98% of estates. What most people do not realize is that the repeal of the estate tax causes the sale of estate items by family members to incur capital gains taxes for the sake of avoiding the estate tax that hits only 2% of the estates in our country. And in the end, the federal government may actually receive a lot more revenue from estates that never would have come close to paying death-related taxes.

Here’s how the estate tax works:

  • With an estate tax, when a person passes on everything they owned is added up at fair market value.
  • it is irrelevant what the “tax basis” was in the property, meaning what the deceased person actually paid for their property days, months, or years before
  • if the total estate at fair market value is more than the estate tax limits, then taxes are paid on the excess; if it was not, then there are no estate taxes
  • now all of the assets that belonged to the deceased person have a new tax basis equal to the fair market value on the date of death
  • if the heirs turned around and sold all of the assets of the deceased person for the date of death values (fair market value), there would be no capital gains taxes

If you eliminate the estate tax, then you also eliminate this recalculation of the tax basis. This means that, with the repeal of the estate tax, when the heirs sell assets at fair market value, it is very likely there will now be capital gains taxes. Probably the best way to understand this is to examine a sample estate with the estate tax and then without it.

For 2017, the estate and gift tax exemption is $5.49 million per individual, up from $5.45 million in 2016. That means an individual can leave $5.49 million to heirs and pay no federal estate or gift tax. A married couple will be able to shield just shy of $11 million ($10.98 million) from federal estate and gift taxes.

Estate with Estate Tax

If the estate tax limits are $1 million and someone passes on owning a home worth $500,000 on the date of death which they paid $250,000 for and a stock portfolio worth $500,000 on the date of death which they paid $250,000 for, his only child would inherit the $1 million in assets. If the child sold the house for $500,000 and the stock for $500,000, there would be no taxes at all. This is because the total estate was worth $1 million, which is at the estate tax limits and it is irrelevant what the father paid for the assets; they get a “stepped up” tax basis equal to the fair market value on the date of death.

Estate Without Estate Tax

Let’s take the same estate with the same assets, but the man passed on with no federal estate tax. If the son sold the house and the stock he would have to pay capital gains taxes on the $250,000 gain for the house ($500,000-$250,000) as well as the $250,000 gain for the stock ($500,000-$250,000). At the 28% capital gains tax rate, this would equate to $140,000 in taxes and at the 15% capital gains tax rate $75,000 in taxes… for an estate that would not have any estate taxes.

While it sounds like a victory to “repeal the death tax,” making the estate tax go away, the fact is the loss of the boosted tax basis will have a lot more families paying a lot more in taxes associated with the death of a loved one. There may be some creative solutions to help avoid some of these hidden death taxes, but most would consider the solutions a lot of work.