As we move into 2010, we inherit the much-anticipated repeal of the estate tax for one year—the repeal that had a lot of people joking that 2010 would be the best year to pass on if you had to. It also had the effect in some circles of saying the repeal of the estate tax was an equalizer between married couples and unmarried couples since married couples did not have to pay any estate taxes, regardless of the size of the estate, when the first spouse passed on. However, on January 1, 2011, the law that gave us the repeal of the so-called death tax sunsets and we are left with the tax rules in place prior to 2001 that provided a $1 million estate tax credit per person. But are we really better off without the estate tax? Should we heed the calls to “make the repeal of the death tax permanent”?
Most people would assume that the repeal of any tax is a good thing no matter what the circumstances, but in the repeal of the estate tax that affected about 2% of estates we actually lose a tax benefit to 100% of estates. 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.
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,” 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 in 2010 than if the estate tax stayed in place. 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 considering the estate tax repeal is scheduled to only last for one year. And so the joke shouldn’t be that 2010 is the best year to pass on if you had to go; it should be revised to advise getting a good calculator to see if 2010 really is the best year to go.