Due to changes enacted by the 2001 EGTRRA, the federal estate tax exemption has risen from $1,000,000 at the beginning of the decade to $3,500,000 last year to an unlimited amount in 2010. Because of this, the number of families affected by the Federal Estate tax has decreased dramatically, and in turn, the planning needed to avoid these taxes has been relegated to a select few.

This is only one small part of the overall estate tax question, though. One of the greatest benefits allowed by the IRS in previous years has been a step up in the basis of inherited assets. (The basis of the asset is equal to the asset’s cost, plus improvements, less depreciation.) Even though assets might be included in a decedent’s estate for estate tax purposes, those same assets could avoid substantial capital gains taxes to the beneficiaries on highly appreciated assets. However, in exchange for an unlimited estate tax exemption this year, this unlimited basis step up is removed and in its place a more labyrinthine system for determining the basis of assets is to be applied.

The rules for 2010 provide for a modified carry-over basis that is determined by both the initial basis of the assets and the status of the beneficiaries who are to inherit those assets. Upon a person’s death, the starting point for determining the new basis of an asset is the lesser of the decedent’s basis or the fair market value of the asset as of the decedent’s date of death. From that starting point, the decedent’s estate is allowed an additional allocation of $1,300,000 for any property in their estate and an additional $3,000,000 for property passing to a surviving spouse either directly or through a properly formed trust. * Additional factors that can contribute to a modified basis are unused capital losses, net operating losses, or other losses built-in to the asset value. Taking these modifications into consideration, the basis of the asset may not increase above its fair market value as of the date of death, even if it means a portion of allowable allocation is not used.

Once the amount of additional basis allocation allowed is determined, the estate Executor is still left with the daunting task of deciding how much of that allocation will be allotted to each individual asset. Imaginably, this is a tricky task in an estate with multiple assets and multiple beneficiaries inheriting assets with different basis starting points. Is an Executor to divide the allotted amount equally among the assets without looking to the final basis or would it be more fair to equalize the final basis amounts even if it means one asset receives a great allocation of the allowable step up amount? This area seems rife with accusations of bias especially in estates with a large amount of specific bequests of low starting basis stocks or real estate.

Next year this law changes again when the EGTRRA provisions sunset. The estate tax exemption will return to $1,000,000- including life insurance- with the step up in basis rules revering to a full step up at death. However, since the return of such a low exemption amount would capture more middle American families, especially small business owners, it seems likely that another change is in store for the federal estate tax. Exactly what that change will be is anyone’s guess right now…
*These rules apply only to U.S. citizens and residents.