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Years ago Steve Martin, Chevy Chase and Martin Short did a film called "Three Amigos". At one point in the film a small child in a Mexican village approaches Chevy Chase's character and asks "Can I have your watch when you are dead?" Sure kid, just be thankful I kept the receipt since I bought it thirty years ago.
In 2001 the federal government passed a tax act intended to increase the estate tax credit to $10 million and phase it out in 2010 with the complete elimination of the estate tax. This act currently sunsets in 2010. This means after 2010, all the tax rules reset to the 2000 rules, unless the government decides to adopt the act for an extended period of time. As the tax laws are currently written, and considering the federal government has not taken any action to extend the act, this creates a one-year window without any estate tax.
Unfortunately, the elimination of the estate tax in 2010 is a tax treat with a mixture of sweet and sour flavors. In simplicity, the current tax law, the tax law in 2011 and afterward, when the 2001 act sunsets, takes a two-part approach. First, any asset left by the decedent receives a new tax basis at its current value, with no gain recognized on the increase in basis. Second, the government taxes the estate at the new, higher basis. So, as not to burden everyone with the nuances of the estate tax, and minimize its administration, the government enacted a credit against the estate tax to only tax estates on amounts exceeding $650,000. The 2001 act increased the exemption to $1 million for that year, increasing to $10 million in 2009. Currently, in 2004, the exemption is $2 million. The value above the exemption is taxed at a flat rate between 45% and 48%, dependant on the year in question.
Anyone receiving property distributed by the estate receives the property with a basis equal to the value it had at the time the decedent passed on. For example, assume taxpayer A bought a house twenty years ago for $1 Million, passed away when the house was worth $5 million in 2004, and left the house to taxpayer B. The estate would have a tax of $1.44 million due, 48% of the amount above $2 million. Taxpayer B would have a basis of $5 million in the house, the value of the house at the time taxpayer A passed away, and the same value used when determining the estate tax. If taxpayer B sells the property (in order to pay the estate tax and receive the inheritance) for $5 Million, taxpayer B has no gain on the sale because taxpayer B's basis is equal to the sale price.
Then, for the year 2010, everything changes. The estate tax is eliminated, and with it goes the credit, and the increase in property basis. In return comes a record-keeping headache.
When congress eliminated the estate tax they knew they were eliminating a substantial source of revenue. They intended to make up this revenue through capital gains taxes on sales made by the beneficiaries of an estate. Unlike the rule under the estate tax, property no longer receives a basis equal to its value at the time the original owner passes. Under the rules in place for 2010, the property beneficiaries receive, will have the same basis as the decedent. For administrative feasibility, the government has included a $1.3 million step up in basis. As a result estates valued less than $1.3 million can just use the value of the property at the time the decedent passed away.
The tax effect of this change can best be observed in the previous example. The estate would have no tax due, as there is no estate tax in 2010. Taxpayer B would have a basis of $2.3 million in the house (taxpayer A's basis in the property, plus the $1.3 million step up). If taxpayer B sells the property after receiving it for $5 Million, taxpayer B has a capital gain of $2.7 million, and a capital gains tax, at 15%, of $405,000 when sold.
The tax under the 2010 rules is considerately less. However, how much less is where the trap lies. To comply with the tax rules and have any basis beyond the $1.3 million step up beneficiaries need to know the decedent's original basis in the estate. This becomes even more important when considering capital gains rates will also return to the year 2000 rate of 28% when both the 2001 and 2003 tax acts sunset after 2010. In the previous example, if Taxpayer B opts to wait a year, until 2011, to sell the same house, and they couldn't verify taxpayer A's basis of $1 million, they would have a capital gain of $3.7 million ($5 million minus the $1.3 million step up in basis) and a capital gains tax of $1,036,000.
Simply asking a taxpayer what they paid for a given item easily relieves most basis questions. Unfortunately, that option doesn't exist in the case of a decedent. While the taxpayer may have kept excellent records regarding their basis in their assets, their beneficiaries aren't keeping those same records. If the beneficiaries aren't able to sort through the records or even find them, assuming they've been kept in the first place, they won't do them a bit of good.
Many people spend a great deal of time and money on estate planning. They want to make sure their beneficiaries receive as large a share as possible and the government as little as possible. The downside is we can only guess when we're going to pass on; we can't predict the day with any kind of accuracy. If we could, most of us would be living our lives in a much different manner.
People base their estate planning on those same assumptions. Unfortunately, most people plan for the most likely set of rules at the time of their demise, and then change their position if they survive into a new set of rules, or the rules change along the way. They don't plan for small inconsistencies such as the 2010 rules.
If you're spending the time and money on estate planning, make sure to account for the 2010 rules. Contact your accountant or advisor for specifics regarding your situation, and any assistance you may need for determining your basis in your property. The rules for basis aren't always as straightforward as purchase price. Make sure your executor and accountant have records for your property's basis, as well as the copy you keep for yourself.
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