There has been a lot of debate over whether or not to cut taxes federal taxes, which naturally brings up the debate over the federal estate tax. And here is the review I often have to give my clients of what the law currently is, because without the history they just don’t seem to believe its possible because it doesn’t make sense. Of course, that’s how you know Congress came up with it. Back in 1996, the estate tax exemption amount was $600,000 per person, and it was decided to raise the exempt amounts over a ten year period to $1 million per person. Well, in 2001 Congress decided that things were not going quickly enough, and they raised the exemption to $1 million right away and then steadily increased it so in 2007 and 2008, it was $2 million a person, in 2009 it was $3 and a half million a person, and in this year, 2010, there were no estate taxes at all… for one year. Then the 2001 law expires, leaving the 1996 law in place that said starting in 2006 it would be $1 million per person forever, or until Congress makes a change.

Now the natural inclination is to want to eliminate the estate tax entirely because people think that’s what would benefit all of the taxpayers. The thing is, it’s not that simple. Eliminating the estate tax on the estates of the wealthy means that all estates end up being subject to capital gains taxes when assets are sold. Let’s take a closer look at the changes to the tax laws and see how it affects people:

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.

In an Estate with the 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, the family would inherit the $1 million in assets. If the family 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 deceased person paid for the assets; they get a “stepped up” tax basis equal to the fair market value on the date of death.

In an Estate Without the Estate Tax, and using the same estate with the same assets, but the person passed on with no federal estate tax in place. If the family sold the house and the stock they would have to pay capital gains taxes on the $250,000 gain for the house as well as the $250,000 gain for the stock. 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 had any estate taxes at all. While it is possible that capital gains tax credits could be applied, between 70 and 75 percent of people die without a written plan that would apply the credits.

While it sounds like a victory to “repeal the death tax,” the fact is the loss of the boosted tax basis upon death will have a lot more families across the board paying a lot more in taxes associated with the death of a loved one than if the estate tax stayed in place. Or better still, the tax stayed in place but the exemptions were raised. As with many things in law and politics, it’s easy to throw out a soundbite like repeal the death tax. Unfortunately, it means that the very few families of deceased billionaires would have massive inheritances gains at the expense of middle class estates paying capital gains taxes they never would have had to pay if there were an estate tax in place.