Estate Tax Sunset Creates Capital Gains Problems

The financial media treated the demise of the estate tax in 2010 as a bonanza for the heirs of those who die with an estate worth more than $3.5 million, which was last year’s exemption amount. Those heirs will owe no estate tax no matter how large the estate. Like any issue that has to do with the tax code, however, things aren’t that simple. The death of the so-called “death tax” created a capital gains trap that could hit many more taxpayers than the old estate tax would have.

According to the tax code, when an estate tax is in place, the cost basis of any assets in the estate is “stepped up” to their value on the date of death. This year, when no estate tax is in place, there is no step-up in basis. Heirs that sell the assets owe capital gains taxes on any amount over the cost basis of the asset. An oversimplified example: If your grandmother leaves you stock that she bought at $10 a share and it’s now worth $100, you’ll owe capital gains tax on $90 a share if you sell it. But computing the tax basis on shares that could be decades old would be a nightmare, because you’d have to trace things like splits, dividends, and mergers. There is one break — heirs that aren’t spouses of the deceased can add $1.3 million to the basis of the assets.

In the case of spouses, even the wealthy won’t get off scot-free. Under the old estate tax rules, a surviving spouse would owe no estate tax, no matter how large the estate. This year, the surviving spouse will owe capital gains tax on any assets that are sold, after adding $4.3 million to any basis that his or her spouse had in the assets. One caveat: Congress could reinstate the estate tax and make it retroactive to January 1, which would create its own set of problems. For more information on the impact of the estate tax demise, talk to your tax advisor.