Federal Estate Tax Repealed, But "Carryover Basis" Rules Instituted, In 2010

Contrary to the expectations of many practitioners including the writer, Congress did not amend the federal estate tax laws in 2009. As a result, the Economic Growth and Tax Reconciliation Act of 2001 (“EGTRA”), passed by President George W. Bush, controls. EGTRA makes substantial changes to the  federal estate tax laws in 2010 and thereafter. A summary of EGTRA’s effect on federal tax law follows.

Under EGTRA, the federal estate tax, as well as the Generation Skipping Transfer Tax (GST), were repealed on January 1, 2010. As a result, the estates of people who die after December 31, 2009 are not subject to either federal estate tax or the GST. However, under EGTRA the estate tax and GST will be reinstated automatically next year, on January 1, 2011, at the levels of taxation in effect in 2001 ($1 million per person exemption and 55% top rate). In other words, the federal estate tax and GST were repealed under EGTRA, but only for one year, in 2010. After the year 2010 ends, the federal estate tax and GST will be automatically reinstated in 2011 at a much lower individual exemption amount and much higher tax rate than had been in effect since 2001.

Other significant provisions in EGTRA that took effect on January 1, 2010 include changes to the federal gift tax, which remains intact but at a reduced rate of 35% and with a $1 million lifetime exemption. In addition, “carryover basis” rules took effect, which means that property acquired from a decedent through inheritance will retain the decedent’s tax basis in the hands of the beneficiary, with certain exceptions.

The change in the basis rules merit particular attention. For many years prior to January 1, 2010, property inherited from a decedent received a new basis for tax purposes. The fair market value of the property on the date of the decedent’s death became the new basis of the property. This is  commonly referred to as the “stepped-up basis” rule. The stepped-up basis was advantageous to beneficiaries who sold inherited property when the value of the inherited property had increased during the decedent’s ownership of the property. Using the stepped-up basis rule, little, if any, capital gain was realized on a sale of inherited property by the beneficiary. The reason is because capital gain is calculated by subtracting the tax basis from the sales price, and when the tax basis is stepped-up to the fair market value of the property, the difference between the tax basis and the sales price is usually zero. As of January 1, 2010, however, EGTRA changed the basis rules. Beginning this year, property inherited from a decedent retains the tax basis that the property had at the time of the decedent’s death (commonly referred to as the “carryover basis”). Assuming that the inherited property increased in value during the decedent’s ownership of the property, the carryover basis is detrimental to beneficiaries who sell inherited property. There are two exceptions to the carryover basis rule: first, EGTRA allows for an increase of up to $1.3 million in the basis of certain assets owned by the decedent, and, second, an increase of up to an additional $3 million in the basis of property is allowed under the law for property passing to the decedent’s surviving spouse.

The change in the basis rules is expected to adversely affect tens of thousands of estates. It is now important for taxpayers to investigate the decedent’s basis in inherited property. Unless the beneficiaries can provide information about the decedent’s basis in the property, the law presumes that the basis of the inherited property is zero, resulting in substantial capital gains tax liability for beneficiaries who sell the inherited property.