The Perils of No Estate Tax

As everyone knows, nothing is certain but death and taxes.  This year, however, there is a lot of uncertainty surrounding estate taxes, and a lot of misunderstanding about how the new rules will affect the average real estate investor. 


In 2001, Congress voted to gradually phase out the federal estate tax, which had been as high as 55%.  The law was temporary, and although federal estate taxes have been completely eliminated in 2010, the law has a sunset date of December 31, 2010.  Without further action, the old estate tax rules will return on January 1st, 2011.  Although many people expected Congress to intervene and change the law this year, so far nothing has happened. 


The lack of federal estate tax this year is not necessarily good news for all people who inherit property.  For one thing, many states still have state estate tax.  In addition, with the repeal of estate tax, there is also a repeal of a significant benefit for real estate investors – the step up in basis. 


How does the step up in basis work?  Typically, when real estate is sold, the gain is the difference between the price at which it is sold and its basis, which generally is the price at which the investor acquired the property.  However, when you inherit assets, they receive a full step up (or step down) in basis to the fair market value of the asset at the time of death.   If heirs immediately sell an inherited asset, there is no taxable gain.  Unfortunately for real estate owners, the repeal of the estate tax ended this step up in basis benefit, which means that this year heirs who sell newly inherited assets may face a substantial taxable gain.


For example, let’s look at Brad.  Brad is an unmarried individual who owns an investment property with a fair market value of $200,000 and a basis of $100,000.  Brad’s total estate is valued at $2 million.  If Brad died in 2009, the entire value of his estate would have fallen within the amount exempt from federal estate taxes.  In addition, Brad’s heirs could have inherited the investment property and been able to sell it at a stepped up basis, resulting in no taxable gain.  However, if Brad dies this year, even though his estate will not be subject to estate taxes, if his heirs choose to sell the investment property, they will have a gain of $100,000 and owe $15,000 in federal capital gains taxes.  


The existing law does still provide for a modified carry over basis. As a general rule, up to $1.3 million of basis can currently be allocated to the estate’s assets.  Additionally, if the property is passing to a surviving spouse, the estate receives an additional $3 million, for a total of $4.3 million of carry over basis to allocate to the assets in the estate.  The basis calculation and allocation rules are lengthy and complicated.  For some estates, allocation strategies can be used so that the benefit of the repeal in the estate tax outweighs any burden created by the change in basis calculation. For others, heirs may have to explore alternative tax deferral tools such as a 1031 exchange when disposing of inherited assets.


There is a chance that Congress will act this year regarding both the estate tax and the step up in basis, and any new tax legislation could be retroactive to the beginning of 2010.   In any event, it is important for investors to re-examine their estate plans and consult with their tax advisor to make sure they have addressed these issues.