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Estate tax: Choose the ‘old’ rules … or the ‘new’ rules

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in Small Business Tax,Small Business Tax Deduction Strategies

The federal estate tax was repealed for just one year—2010—before being reinstated. Now the new 2010 tax law (SBTS, January 2011) provides some relief going forward. And, if a relative passed away in 2010, your family still can benefit from the one-year repeal.

Strategy: Bypass this estate tax break. Under the new 2010 Tax Relief Act, you can choose to have the rules taking effect in 2011 apply to the estate of someone who died in 2010. In the majority of cases, the heirs will come out ahead.

Of course, you must crunch the numbers to ensure that this option makes the most sense for your family.

Here’s the whole story: The massive 2001 tax law known as EGTRRA (the Economic Growth and Tax Relief Reconciliation Act) gradually raised the federal estate tax exemption from $1 million to $3.5 million, while lowering the top estate tax rate from 55% to 45%. Under EGTRRA, the estate tax was repealed for 2010 in conjunction with the imposition of modified “carryover basis” rules. Then the estate tax was scheduled to return in 2011 at pre-EGTRRA levels.

The new 2010 Tax Relief Act creates favorable rules for the two years extending from Jan. 1, 2011, through Dec. 31, 2012. If it suits your needs, you can also choose to use the “new rules” instead of the “old rules” for a decedent dying in 2010. Here’s the rundown.

Old rules: As we’ve said before, the estate tax bill is zero. But choosing this option will often cause income tax complications. Reason: Instead of using the prior rules allowing a “step-up” in basis to the value of assets on the date of death (see box below), the heirs carry over the decedent’s adjusted basis in the assets. If the property has appreciated substantially, the heirs might owe a big capital gains tax bill when it is sold.

The income tax gain can be reduced by two basis adjustments:

  • An increase up to $3 million for assets transferred to a spouse
  • An increase up to $1.3 million for assets transferred to any beneficiary.

Example: You’re the sole beneficiary of your father’s estate. He died in 2010. Your father paid $500,000 for a home decades ago that’s now worth $2.5 million.

There’s no estate tax if you choose to use the old rules.

However, if you sell the home in 2011 for $2.5 million, your taxable gain for income tax purposes is $700,000 ($2.5 million – adjusted basis of $1.8 million after the $1.3 million basis increase). Based on the maximum 15% tax rate for long-term capital gains, you’ll owe $105,000 in federal income tax (15% of $700,000).

Be aware that it can be difficult to figure out the adjusted basis of property that relatives have owned for years, such as real estate and securities.

New rules: The estate tax applies, but the heirs benefit from a $5 million exemption. So there’s essentially no estate tax for estates valued at $5 million or less. In addition, the modified carryover basis rules don’t apply. The value of the inherited assets is stepped up to the value on the date of death. Assuming inherited assets are sold in the near future, the heirs will likely owe little or no income tax.

If the estate’s value exceeds the magic $5 million mark, it may still be worthwhile to pay a little estate tax to avoid a bigger income tax bill.

Example: You’re the sole beneficiary of your mother’s estate. She died in 2010. The value of her total estate is $6 million with an adjusted basis of $2 million.  

The estate tax that is due, after the $5 million exemption, is $350,000 if you choose to use the new rules. But there’s no income tax if you sell the inherited property in 2011 for $6 million. Conversely, if you choose the old rules, you reduce the estate tax to zero, but your income tax liability will be $405,000 ($6 million – adjusted basis of $3.3 million x 15% long-term capital gains rate). Overall tax savings: $55,000 ($405,000 – $350,000).

Tip: Work through both scenarios. Usually, the new rules will produce a better overall tax result.

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