Why the Estate Tax Repeal in 2010 May Hurt Many Americans

There is a hidden trap for middle-income Americans in the repeal of the estate tax for 2010.  What most people don’t know is that also repealed along with the tax is the provision which allowed beneficiaries to receive a “stepped up basis” in assets which they inherited.  Many Americans who inherit assets in 2010, without that stepped up basis, will be exposed to a capital gains tax on the increase in value from the time the assets were initially purchased until the time they are sold. 

            Those wage earners in the lowest income tax brackets (10% and 15%), which includes married couples earning up to $61,300.00, will be somewhat protected by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), because that law dropped the capital gains rate for people in those brackets to 0% for the years 2008 through 2010.  (But, if the gain on inherited assets puts you over that amount . . .)  For a large number of Americans in the 25% - 35% brackets, capital gains taxes on the sale of inherited assets will be owed, when no tax would have been owed had the current estate tax law remained in effect.

            In 2009, everyone had a personal estate tax exemption of $3.5 million dollars.  Accordingly, if a person died in 2009 with less than $3.5 million dollars in assets, all of those assets could be devised to their loved ones without any estate tax.  Additionally, those assets would have passed with a “stepped up” basis, meaning that the beneficiary would inherit those assets at the monetary value of the assets on the date of the decedent’s death.  In 2010, there only will be an exemption for the first $1.3 million dollars of capital gains within an estate.  It is estimated that 70,000 estates will owe taxes under this “repeal”, whereas only 5,500 estates would have been affected had the current estate tax law remained in place.

            To illustrate:  Suppose Dad already has passed away and Mom died in 2009.  You are her beneficiary.  At the date of her death, she owned the family home in which she has lived the past 40 years.  It had a value of $510,000 on Mom’s date of death.  It was purchased 40 years ago for $10,000.  Mom also left oil stocks valued at $1,510,000, which had been inherited from her grandmother.  When her grandmother purchased those stocks many, many years ago, she paid $10,000. 

            In 2009, because this estate was valued at $2,020,000, no estate tax would have been due.  (estate is less than 3.5 million)  You would have inherited the home, with a basis of $510,000 and you would have inherited the stock with a basis of $1,510,000.  If you then turned around and immediately sold each asset for those prices, you would have owed no capital gains tax from the sale.  Total tax to the estate would have been zero.  Total tax to you would have been zero.

            Now, compare what happens if Mom dies in 2010 under the same scenario.  Again, there is no estate tax to Mom.  However, if you turn around and sell the home and the stocks for their face value, you will owe capital gains tax on $2 million dollars in gain.  ($2,020,000 value - $20,000 cost).  After your 1.3 million dollar exemption, you would pay 15% capital gains tax on $700,000.  This will result in a $105,000 tax bill for you in 2010, which would NOT have been owed had the current estate tax law been continued.

            In this example, tax would be owed even if you are in the 10% or 15% tax bracket because the 0 % capital gains tax rate only applies to gains, which added together with your income, would still fit within those brackets.  So, if you and your spouse together earned $60,000 and then had a $2,000,000 capital gain from the sale of inherited assets in 2010, you would pay the full 15% ($105,000) on the sale of those inherited assets. 

            If you are married, it is even worse.  Under the current law, you could leave your entire estate to your spouse tax free.  Now, you only can leave $4.3 million dollars in assets with capital gains to a surviving spouse. This is a large amount, but it is not unlimited like it has been for decades.

            Accordingly, a significant number of Americans who receive inherited assets in 2010 will be worse off for the repeal of the estate tax.  Who is better off?  . . .  the extremely wealthy, those one percent (1%) of the population who may have estates worth more than $3.5 million and pass away in 2010.  Then, instead of an estate tax rate of 45% on the amount of assets greater than $3.5 million, the beneficiaries of those estates would pay only a 15% capital gains rate on the actual capital gains owed on those inherited assets. Thus, the repeal of the estate tax in 2010 is a boon for the most wealthy among us, of little concern to the least wealthy, but is a major concern to many people in the middle.