Federal Estate Tax "Death" in 2010 Creates Capital Gains Trap

Sigh ... I was really, really hoping I would not have to post about what happens to those who die in 2010 from a federal tax perspective.  However, since Congress couldn't seem to get its act together, here is the current 2010 landscape (with the caveat that Congress can act in 2010 and have a retroactive estate tax - but, we will have to see what happens when it happens).

Did you know that the "death" of the estate tax creates a capital gains "trap"?  And that "trap" catches the smaller estates, the ones that under current tax laws have no federal tax consequences on death. 

Assume you are single person with a $3.5 million estate (I will post separately about married couples).  Had you died in 2009, there would have been no federal tax consequences to your death.  If you die in 2010,  there will no federal estate taxes (same as 2009).  However, your heirs will have to pay capital gains taxes (see, there is always a catch).

What??? you say.  I thought death was tax free in 2010.  It is estate tax free, there won't be a federal estate tax.  There will, however, be federal and state capital gains taxes for deaths in 2010. Why??? you ask.  Well, there is a pesky little section of the Internal Revenue Code (1014) that says, essentially - 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, when she dies it is worth $100.  Son inherits stock and sells for $100.  His capital gains is $0 ($100 of value - $100 of basis =0).  Section 1014 is a neat magic trick - it makes capital gains taxes disappear.  In tax parlance we call this a "step-up in basis".

However, in 2010 there will be no estate tax, and therefore no step-up in basis.  Let's take the same example where mom bought stock for $10, and when she dies it is worth $100.  Son inherits stock and sells for $100.  He now has a capital gain of $90 subject to tax ($100 of value - $10 of basis = $90).  He must pay federal capital gains tax on this amount (15%) and state capital gains tax (7.5% in New Jersey) for a total tax of $20.25 if he is in NJ - or $15 if he is in FL or another state without a state estate tax.  

Notice that when mom died in 2009 with an estate tax in place, son netted $100.  However, when mom dies in 2010 with no estate tax in place, son only nets $79.75. Lets add some zeros - son nets $1,000,000 if mom dies in 2009, but only $797,500 if she dies in 2010.  Now you see how no estate tax is not necessarily a good thing?!

The above is over-simplistic, but it makes the point that the "death" of the estate tax creates a capital gains trap.

One point of "relief" - your estate will be able to allocate $1.3 million to add basis to inherited assets (different rules apply for a surviving spouse) per code Section 1022.  To continue our example, mom's entire $3.5 million estate consists of stock she bought for $10 a share and is now valued at $100 a share.  Her cost basis in her estate is $350,000.  She dies, and the estate has an additional $1.3 million of basis - so the stock now has a total basis of $1,650,000.  Son sells the stock for $3.5 million, creating a capital gain of $1,850,000, which in return has son paying a federal capital gains tax of $277,500 (or $416,250 if he is in NJ).  Remember now, if mom had died in 2009 when there was a federal estate tax, son would have paid $0 in tax.

But the the so called "relief" is a trap too - how are you going to prove basis?  How do you know what mom paid for each stock share?  And if you do know, what about splits, mergers, stock dividends - what is her cost basis in all those?  Tracking basis for assets acquired over a person's lifetime, particularly when the person is now dead, is a nightmare.

Congress has "promised" to reinstate the estate tax to January 1, 2010 - and I think we all know what weight to give to Congresses promises.

My next post will address what happens if mom dies in 2010 survived by dad  (a spouse) - and the picture isn't rosy there either.

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Comments (4) Read through and enter the discussion with the form at the end
Kasey Libby - May 12, 2010 8:38 AM

I read section 1014 and don't see where it only applies to estates subject to estate taxes. I do see subsection (f) which states the stepped-up basis provision terminates on December 31, 2009. Isn't that the provision to be concerned about?

David B Stanton - June 21, 2010 7:53 PM

Is there a value threshold that the estate must be accessed at before it is subject to estate taxes or at which time it is subject to capital gains taxes? Put another way, does the estate have to achieve a minimum value before the capital gains taxes apply to that estate,or does it apply evenly across all estates, regardless of value of the inherited assets? Or, when is an estate subject to estate taxes?
Thank you,
David B Stanton

Lili - February 4, 2011 7:57 PM

My mom passed away in march 2010, leaving no will and 5 heirs(children) Value of her home is 1.5 million which was bought years ago for 52,000. How do I calculate the nj tax due?

Deirdre R. Wheatley-Liss - February 7, 2011 7:37 AM

The rates for calculating the NJ estate tax are available at http://www.state.nj.us/treasury/taxation/pdf/other_forms/inheritance/o10c.pdf. The tax on a $1.5 million gross estate will be around $65,000. You should be aware that the New Jersey estate tax payment and return are due 9 months after death, so you may be incurring interest and penalties if your mom passed away in March of 2010.

Please contact me directly if I can be of further help.

- Deirdre R. Wheatley-Liss

I also need to give a disclaimer that this response is for informational purposes only and that our law firm only creates an attorney client relationship by entering into a written engagement letter.

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