Estate Tax Repeal — Update
The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually phases out the federal estate tax until its complete repeal in 2010. Without additional legislation, however, the federal estate tax will return in 2011.
Since 2001, there have been several efforts in Congress to make the estate tax repeal permanent. Most recently, the House of Representatives voted in April 2005 to do so. That bill is still pending in the Senate, but if passed, it will go to President Bush who has said he will sign it into law.
The question is: Will permanent repeal become law, and if so, what are the potential ramifications?
Goodbye estate tax, hello capital gains tax
Repeal does not mean that tax on wealth transfers from one generation to the next will disappear. While currently a tax is imposed on estates, after repeal, a tax will be imposed indirectly on inheritances in the form of capital gains tax. Here’s a simplified explanation.
Under the current tax system, property that is transferred to heirs at the owner’s death typically gets a “step up” in tax basis. Generally, tax basis refers to the cost the owner paid to acquire the property, and is used to compute capital gains tax when the property is sold. For example, let’s say Mr. Smith buys property for $50,000, which becomes his tax basis, and sometime later sells the property for $60,000. Mr. Smith’s computed capital gain for tax purposes is $10,000.
When property is transferred by gift, the recipient receives a “carry over” basis; the tax basis in the hands of the person making the gift generally becomes the recipient’s tax basis. So, let’s say that Mr. Smith gives the property in the above example to his son, John. Mr. Smith’s $50,000 tax basis carries over to John, and when John subsequently sells the property for $60,000, John recognizes the $10,000 capital gain.
When property is transferred because of the owner’s death, however, the tax basis is stepped up to its current fair market value.
Again using the first example, let’s say that John receives the property through his father’s will. John’s tax basis is stepped up to $60,000, the property’s fair market value. When John subsequently sells the property for $60,000, John recognizes no capital gain on the transaction.
One of the consequences of estate tax repeal will be that the step up in tax basis will be lost. Heirs will receive a carry over basis on inherited property, and will recognize the capital gain (or loss) when the property is sold at some point in the future.
What will this change in the tax system mean for American families? The current estate tax affects 2% of the most wealthy Americans. Capital gains tax, on the other hand, can affect anyone who owns capital assets. Therefore, unless the step up in basis remains, estate tax repeal is likely to result in creating a higher tax bill for a greater percentage of less wealthy Americans. Further, repeal will create a paperwork headache for heirs who will have to determine the decedent’s tax basis in the property they’ve inherited.
Dealing with the uncertainties of the estate tax
The uncertainty about the long-term prospects of the estate tax is a conundrum. Whether you’re willing to bet the estate tax will be permanently repealed or you believe the estate tax is here to stay, planning in advance is as essential as ever. Here are some important facts to keep in mind:
* Though estate tax may be repealed, gift tax will remain. Gift tax planning is still critical to your overall estate plan.
* The estate tax phases out through 2010 by increasing exemptions and decreasing rates. Make sure your will and trusts include formula provisions that take care of these changes automatically.
* Estate planning meets other goals besides tax avoidance. You still need to plan to take care of your surviving family members, avoid probate, distribute your estate according to your wishes, make charitable gifts, plan for incapacity, and meet many other objectives.