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Retirement

The "Death Tax" Lives

To paraphrase Mark Twain, reports of the death of the federal estate tax are greatly exaggerated.

A funny thing happened on the way to the funeral for the federal estate tax. In December, Congress announced its own Christmas miracle: The tax didn’t really expire December 31, 2009, as everyone thought it had. Instead, the lawmakers retroactively revived the tax to cover all deaths in 2010. But get this. The lawmakers also performed a stutter-step move worthy of a great wide receiver: Any 2010 estate that’s better off ignoring the tax can do just that.

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A little background is needed to explain this strange turn of events. You’ll recall that part of the 2001 Bush tax cuts was to gradually reduce the bite of the estate tax, kill it all together for 2010, and then allow it to come back with a vengeance in 2011. The plan was to reinstate the estate tax with the $1 million exemption level and 55% tax rate that was in effect in 2000.

But that won’t happen. Under the new law, for 2010 and 2011, up to $5 million can go to heirs tax-free (and that number will be indexed for inflation for 2012). The tax rate for amounts over the tax-free level is a flat 35%.

Married couples get an even sweeter deal that insures that together they can pass up to $10 million to heirs estate-tax free. If the first spouse doesn’t use up the $5 million exemption, the leftover amount can be added to the widow or widower’s $5 million. In the past, couples needed special trusts to take full advantage of their dual exemptions.

Rethinking 2010 rules

Due to concerns that retroactively imposing an estate tax for 2010 could be challenged on constitutional grounds, Congress decided to give estates of folks who died in 2010 the choice of the 2010 no-estate-tax rules or the $5-million-exemption/35% scheme. Why would anyone opt for the latter?

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Well, there was something of a land mine inside the one-year hiatus of the estate tax. Sure, anything from modest estates to eye-popping fortunes could go to heirs estate-tax free. But the 2010 rules also eliminated the automatic step up in basis for inherited assets. With stepped-up basis, inherited assets go to heirs with a tax basis – the value from which any gain or loss upon sale will be determined – equal to the assets’ value on the date the benefactor died. That means all appreciation prior to death is tax free.

But for 2010, the law assigned “modified carry-over basis,” meaning heirs would be stuck with the original owner’s basis – what he or she paid for the property, or less if it had declined in value– and a capital gains bill when they sell that taxes appreciation before death. The modified version in effect for 2010 allows executors to increase the basis of assets by as much as $1.3 million (plus an extra $3 million for assets that go to a surviving spouse) – thus wiping out the tax on that much appreciation. A special form has to be filed showing how the executor parcels out the stepped-up basis.

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For the vast majority of Americans who died in 2010 – those whose estates are worth less than $5 million – revival of the estate tax is a good deal. Their estates don’t have to pay the tax (or even file a return) and heirs are guaranteed unlimited step up in basis for assets they inherit. We call this the “angel of death” tax break, and it saves taxpayers billions of dollars each year when they sell inherited assets.

For 2010 estates valued at over $5 million – including the estates of several billionaires who died, including New York Yankee owner George Steinbrenner – executors are likely to opt out of the retroactive estate tax rules. They’ll parcel out the maximum basis step up to wipe out future capital gains taxes on $4.3 million of pre-death appreciation and let heirs worry about the tax bill on pre-death appreciation of other assets when they sell them. After all, the estate tax would claim 35% of assets in excess of $5 million while the long-term capital gains rate faced by heirs is currently just 15%.

Got it? Well, don’t get too complacent. The new rules apply only for 2010, 2011 and 2012. The fate of the estate tax is really still in limbo.

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