2010 and 2011 brought big changes in federal estate tax law. In 2010, for the first time since 1916, there was no federal estate tax. But new rules about the tax basis of inherited property left some people potentially liable for more capital gains tax than they would have had to pay under the old estate tax rules. The December 2010 Tax Relief Act instituted more big changes for 2011, including a $5 million per person exemption from estate tax.
Now families of those who died in 2010 have a choice: They can choose to follow either the 2010 or the 2011 estate tax rules. For the vast majority of families, the better choice is the 2011 rules; the $5 million exemption is so large that more than 99.5% of estates won't owe any tax. Here are the details.
If you choose the 2011 rules, the system that took effect January 1, 2011, you will:
Tax basis rules are important because they determine how you calculate your taxable gain when you sell property you've inherited. Stepped-up tax basis means that if you inherit property, the new tax basis of the property is its value on the date of death. As a result, if you inherit property and later sell it, you will pay capital gains tax based only on the value of the property as of the date of death.
For example, say you inherit a house from your father. He paid $150,000 for it many years ago; it was worth $400,000 at his death. If you later sell it for $410,000, your taxable gain would be just $10,000. That's the sales price minus the stepped-up basis.
If you choose the 2010 rules, the system that was in effect in 2010, you will:
Tax basis rules determine how you calculate your taxable gain when you sell property you've inherited. A carryover basis means that the basis of inherited property remains what it was for the previous owner (the person you inherited it from). Usually, the basis is what the person paid for the property plus expenditures for capital improvements. If you sell the property, the amount of your capital gains tax will be based on this older (almost always) lower amount, meaning you will owe more tax.
For example, say you inherit a house from your father. He paid $150,000 for it many years ago; it was worth $400,000 at his death. If you sell it for $410,000, your taxable gain under the carryover basis rules might be $260,000 ($410,000 minus $150,000). You would owe capital gain tax on that amount.
Figuring out carryover basis also presents you with an administrative nightmare. How do you figure out the basis in a house your parents owned for 40 years (you start with the purchase price, but expenditures for capital improvements might have increased the basis) or in stock that was bought 20 years ago and has split several times since?
The 2010 rules gave inheritors up to $1.3 million in stepped-up basis, and surviving spouses could take another $3 million in stepped-up basis -- so for most people, basis wasn't a problem. But if the estate contains more than $1.3 million of gain, it's up to the executor to decide which items in the estate get a stepped-up basis. For instance, in the example above, the executor could decide to give the house a stepped-up basis, which would use up $250,000 of the maximum. However, if the estate also had a business worth $1.3 million, the executor would have to choose which item to give the stepped-up basis to.
If you're dealing with a very large estate and must choose between the 2010 and 2011 rules, you'll need to figure out which choice is more advantageous. That means taking a look at the effect of the different tax basis systems. Will it make more sense to pay some estate tax at a 35% marginal rate, or some capital gains tax at 15%? If you do file an estate tax return, you have until September 20, 2011 (nine months from the date of the Tax Relief Act) to get it in.
Consult an attorney who has experience with inheritance and estate taxes. You can find a lawyer by using Nolo's Lawyer Directory for a list of attorneys in your area.