"Death" of Estate Tax in 2010 creates Tax Trap for Spouses

My prior post was about the federal tax impact for single individuals who die in 2010 (unless Congress does as they have promised and create an estate tax retroactive to January 1, 2010 – we will have to wait and see if that happens and how it is constructed).

The news for single folks was not good. Mom dying with a $3.5 million estate in 2009 could leave it to son tax free. Mom dying with that same $3.5 million dollar estate, assuming the basis of her assets is $350,000, now creates a  federal capital gains tax of $277,500 for son (or $416,250 if he is in NJ).

The news for married folks is worse. In 2009 mom could leave $100 million (or whatever amount) to dad with no taxes whatsoever – there is an unlimited marital deduction from estate taxes (so long as your spouse is a US citizen). In 2010 only $4,300,000 will pass tax free to the surviving spouse.

The "death" of the estate tax creates a capital gains "trap" - and the “trap" catches assets passing to a surviving spouse that were never subject to tax under the estate tax.

What??? you say. How is it possible that by eliminating the estate tax you are creating a tax for widows and widowers? As I noted, due to the magic of Internal Revenue Code Section 1014, capital gains taxes disappear at death under the 2009 law. Section 1014 creates a “step-up in basis” by stating that when an estate is subject to estate taxes, the cost basis of inherited assets is the date of death value.  For example, mom bought stock for $10, and when she dies it is worth $100.  Dad  inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).

However, in 2010 there will be no estate tax, and therefore no “step-up in basis”.  Instead, per Section 1022, Dad can apply $1,300,000 million plus $3,000,000 to add basis to the assets that mom has. How might this work? Let’s say mom has a $6 million estate, made up mostly of the family business she and dad still work in and some real estate. Assume mom has a $500,000 basis in the assets – all that appreciation has been due to increases in value over the years. If mom died in 2009, dad would get $6 million tax free. If mom dies in 2010, and dad sells everything since he doesn’t want to work without his life partner, he only has a basis of $4,800,000  ($500,000 of mom’s basis + $4,300,000 of allocated basis). Since he sold for $6 million, he has $1,200,000 of capital gains. He will owe the federal government $180,000, and if he lives in New Jersey, he will also owe the Garden State $90,000, for a total of $270,000. Remember, had mom died in 2009 when there was an estate tax in place, dad would have owed $0.

It bears repeating that all other concerns aside, this new tax regime where you need to track cost basis over a life time is a nightmare. How do you prove mom’s basis before she died was $500,000? Was every improvement tracked? What documentation will the IRS accept as proof? Will you have that documentation 30, 40, 50 years later?

My next post will address some planning opportunities (every cloud has a silver lining after all) that might exist in this new tax environment.

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Comments (1) Read through and enter the discussion with the form at the end
Daniel - February 1, 2010 1:04 PM

I am concerned with Inheritance, Estate, and Capital Gains Taxes. My wife and I, retired NJ teachers, jointly own homes in NJ(primary residence) and PA. Each property is valued at approx. 400k. I would like to know if my heirs would benefit if I declared PA, rather than NJ, as my primary residence. My wife is my beneficiary and I hers. If either of us were sole survivors, our children would be the beneficiaries. I was told by someone that once I change my primary residence, I have only 2 years to sell the other to avoid a capital gains tax. I have contacted the NJ Department of Taxation. They have an administrative code that prevents them from dealing with hypotheticals.

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