Note: The content of this article applies only to the 2010 tax year. It is included here for reference only. Did your family inherit an estate in 2010? If so, you have a rare opportunity: You can opt to use either the 2010 or 2011 tax rules. For inheritors of large estates, selecting the right approach could result in major tax savings.
The 2010 rules: No estate tax, but potential capital gains tax
There was no estate tax in 2010. Still, people inheriting money weren’t entirely off the hook. The 2010 laws also cut out an important provision that effectively prevented capital gains taxes on inherited estates.
To calculate capital gains tax, the IRS first calculates the difference between an asset’s sale price and its original price, called its cost basis. The result is the asset’s appreciation, which is taxed at capital gains rates.
In years leading up to 2010, inherited assets were treated as if they had been purchased at the value they had when the original owner died. For example, say your uncle left you stock he bought at $10, and at the time of his death the stock traded at $100. If you sold the stock, you would pay capital gains tax only on appreciation above $100. This provision, known as a “step-up” in cost basis, eliminated taxes on any gains that occurred during the original owner’s lifetime.
Last year’s law limited the step-up in cost basis to assets with appreciation of less than $1.3 million, or $4.3 million for inheriting spouses.
The lack of the full step-up provision means estate executors using 2010 rules have to determine the original basis of each asset—no easy feat in many cases. And when inheritors sell the assets, they pay capital gains tax on any appreciation from that original cost.
The resulting tax bill could be significant, especially in the case of stocks or real estate that had been in the family for decades.
2011: Estate tax and step-up come back
The tax compromise legislators hammered out in December 2010 reinstated the estate tax, with an exemption of $5 million per person. (In other words, only the amount that exceeds $5 million is taxed.) The new law also brought back the full step-up rule.
Your choice is relatively straightforward, even if the math involved may not be. You can:
• Use the 2010 rules, which may involve capital gains liability, or
• Use the 2011 rules, which may trigger estate tax.
To make the most prudent decision for your specific situation, calculate the tax using both systems and see which would result in a smaller slice of your pie going to the IRS.
Choosing the right tax rules for your situation
Which tax rules are most beneficial depends largely on the estate you’re inheriting. Consider the following scenarios:
The estate is worth $5 million or less.
In this case your decision is a no-brainer, as long as the deceased’s full estate-tax exemption is intact. (If the deceased made very large gifts during his or her lifetime they could have reduced the exemption.) You’ll want to go with the 2011 rules, because the full value of the estate falls within the exemption—meaning none of it is exposed to estate tax. If you used the 2010 rules instead, your inheritance could include large, taxable capital gains. Choice: 2011 rules.
The estate is worth more than $5 million and its assets appreciated less than $1.3 million from their original cost basis.
Again, this scenario presents a relatively easy choice. If you select the 2011 rules, you’ll most likely pay estate tax on the amount that exceeds $5 million. If you opt for the 2010 law, you’ll have no estate tax. What’s more, appreciation on the assets falls within the amount you can step up—resulting in a tax-free transfer. Choice: 2010 rules.
The estate is worth more than $5 million and contains more than $1.3 million in embedded capital gains.
This situation requires a good deal of number-crunching by a tax professional. If you choose the 2010 rules, you’ll face capital gains tax when you sell any assets to which you don’t apply your $1.3 million step-up. If you go with the 2011 rules, you’re likely to pay estate tax on the amount in excess of $5 million.
Essentially, you have to decide which makes more sense: to pay estate tax on some of the inheritance at a rate of up to 35%, or pay capital gains tax on some of the inheritance when you sell assets (currently a top rate of 15%, although that could change). Consult with your tax professional and attorney to determine the best course of action for you. Choice: 2010 rules if capital gains tax would be lower than estate tax; 2011 if capital gains tax would be higher than estate tax.
Your tax professional and attorney can help you factor state inheritance tax systems into the equation as well: Many had an estate tax holiday for 2010 but have reinstated the tax in 2011, with exemptions and rates varying from state to state. Whatever your decision, you have until September 17, 2011—nine months from the day the new estate tax law came into being—to file with the IRS.