Two Unexpected Issues From the Tax Changes: Why Your Plan May Need a Patch and How to Deal with Long-Held Property

When Congress left the 2001 tax changes in place in 2009, it left two possible traps that may catch some people in higher taxes or unexpected results. One problem is that, with the 2001 changes scheduled for automatic repeal after 2010, no one expected that there would be no changes, and nearly everyone prepared wills and trusts expecting that a permanent change would be in place by now. The other problem is that in 2001, Congress also made a little-noticed change to the capital gains tax effective this year.

How It Works

Estate tax is a direct tax on the right to leave an estate. In 2000, the federal estate tax applied to estates over $1 million. From 2001 to 2009, the minimum was increased in several steps to $3.5 million. In 2010, there is no federal estate tax. In 2011, unless Congress makes a change this year, the $1 million minimum comes back. In counting the value of the estate, everything is included, regardless of whether it passes by will, trust, or otherwise. Jointly held property, life insurance, joint bank accounts, IRAs and anything else you can think of counts.

Oregon and Washington also have estate taxes, which start at $1 million. These are in effect separate from the federal tax and are not likely to be changed.

Capital gains tax is a special form of income tax charged on increases in value on investments when the investment is sold, or the increase is cashed out in some other way. The amount taxed is the sale price minus an accounting concept called basis. Basis is usually the purchase price, with some adjustments for various factors (most notably taking a deduction for depreciation). If you sell your home and buy a replacement, or trade investments, generally the old basis is retained, and you won’t be taxed immediately. (Also, every three years, you’re allowed to cash-out $250,000, and sometimes $500,000 for a married couple, from your home if you’ve owned and lived there for two of the previous five years.)

The Problems

The problem with estate taxes is a matter of planning. The estate tax minimum can be doubled up by taking advantage of the fact that property left to a surviving spouse is not taxed. As a result, it is common for wills and trusts to leave the maximum amount not subject to the federal tax to children and the balance to a surviving spouse, either directly or through a trust. Unfortunately, because there is no federal tax in 2010, that would give everything to the children and nothing to the spouse. People who think their estates may exceed $1 million may want to consider having their wills and trusts changed to include an “if there is no federal estate tax” provision.

The capital gains problem is that when Congress cancelled the estate tax for 2010, it also changed the rules for capital gains. The old rule was that when someone died, the basis for all of their property died with them, and the new basis was set at the value at the time of death (or six months later, at the option of the executor). This “step-up” is now limited to the $1.3 million, plus $3 million for property left to the spouse. As a result, estates worth between $1.3 million and $4.3 million will probably end up having to pay more taxes, in the long run, under the new system.

Fortunately, the executor of the estate can select the property to be stepped up. Usually, this will be the property with the lowest basis that is likely to be sold. The executor should talk to a tax accountant to make that decision.

If there is a dispute in the family as to who gets what property, and someone gets most of the benefit of the step-up, someone else may claim they were unfairly treated. The executor may want to consult a lawyer to make sure the distribution is not challenged as unfair.

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