The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) provided, among other things, that unless Congress took action prior to January 1, 2010 Federal Estate and Gift Tax laws applicable prior to EGTRRA would return as of January 1, 2011. EGTRRA also provided that there will be no federal estate tax for an individual dying in 2010. Most practitioners hoped that the impending January 1, 2010 repeal of the federal estate tax and resulting loss of revenue would motivate Congress to take action prior to January 1, 2010; yet January 1st has come and gone and Congress still has taken no action. Accordingly, most have heard there is no federal estate tax for individual’s dying in 2010. While many are aware of the federal estate tax repeal, many are unaware that the previously permitted “step-up” in an assets cost basis to the fair market value of the asset as of the date of an individual’s death has been eliminated. An asset’s cost basis represents the purchase price of an asset subject to certain adjustments. The elimination of the “step up” in an asset’s cost basis may have significant capital gains tax consequences. The laws in effect for 2010 have softened the potential capital gains tax impact by permitting a limited step-up in the cost basis of estate assets. A step up in cost basis of $1.3 million may be utilized for assets being transferred to a non-spouse and a $3 million cost basis step-up is available for assets transferred to a spouse. So while the good news is an estate will not face a federal estate tax …. the bad news is that the estate’s heirs may very well face substantial capital gains taxes upon the sale of an asset which has appreciated in value significantly since its purchase. For example, heirs of an individual dying in 2010 may be lucky enough to inherit Berkshire Hathaway stock purchased many years ago. Those familiar with the success of Warren Buffet know that the value of that stock has appreciated significantly over time to the extent that it was recently trading for $125,000 a share. Similarly, an estate asset may consist of real estate that has appreciated greatly over time. To illustrate the impact of the loss of an unlimited step up in cost basis consider the estate asset of a single individual, whether it be stock such as Berkshire Hathaway or real estate, which has a date of death value of $4 million and a cost basis of $1 million. Upon the sale of that asset, a potential $3 million of capital gains taxed at 15% is a reality. Although an additional $1.3 million of cost basis can be allocated to the decedent’s original $1 million cost basis, a sale of that asset would still result in a capital gains tax of $255,000 being paid on the $1.7 million in gain ($4 million – $2.3 million). Prior to 2010 there was no limitation to the step up in cost basis such that the cost basis of the asset could have been increased to $4 million eliminating what now may be a capital gains tax of $255,000.
Keep in mind the aforementioned rules apply only for the year 2010. If Congress fails to take action in 2010 to address federal estate taxes as was contemplated upon the passage of EGTRRA in 2001, the federal estate tax will return with a vengeance in 2011. The federal estate tax exemption which allowed all individuals to protect assets of $3.5 million in 2009 (and provided many families a comfort level as to their inheritance) will revert to $1 million per individual for both federal estate and gift tax purposes in 2011. This will subject many individuals to federal estate tax who had not contemplated such a consequence. Should Congress fail to act in 2010 their inaction will have created a “de-facto” federal estate tax increase where the highest estate and gift tax rate would be fifty-five (55%) percent. Let us hope Congress acts responsibly and addresses this issue in the near future so individual’s can properly pursue their estate planning needs.