The 2010 Decedent’s Estate Tax Dilemma – Choosing to utilize the Estate Tax or Opting Out and Understanding Modified Carryover Basis Implications

The purpose of this article is to succinctly explain the options an executor has when dealing with an estate of an individual who passed in 2010 in regards to electing to utilize the Estate Tax or Opting Out and potential tax implications in regards to capital gains.

 

Estate Tax Rates from 1997 to 2013How and Why there is an Option:

First, we must understand why an option exists for 2010. When the Estate and Gift Tax law was updated in 2001, it created a schedule through 2009 – The logic at the time was that by 2009, Congress would have already modified the Estate and Gift Tax law with something “better”. In case of a failure of Congress to modify, the law stated that were nothing to change, the Estate Tax would literally be non-existent in 2010. Meaning there would be no Estate Tax due for decedents in 2010. The law also stated that in 2011, the Estate Tax would revert back to the original figures from 2001. This would have been disastrous, as the 2001 Estate Tax rate was much higher than that of 2009 and subsequently what we have in place now (2011 Estate Tax Rate – 35% with a $5,000,000 exemption).

Before the Estate Tax rates were set to revert to 2001 levels in 2011, Congress acted to change the law in late 2010. It provided a new Estate Tax rate of 35% and a $5,000,000.00 exemption – Additionally, and most importantly for this articles purposes, it retroactively allowed the estate of those who had died in 2010 to have the option to choose whether to “Opt Out” entirely of the Estate Tax (as was the law at the time) or to apply the 2011 Estate Tax law to an individual passing in 2010. Why would anyone elect to apply an Estate Tax when you can simply Opt Out? The answer is Basis.

 

Step Up in Basis:

Basis is a tax term that simply means what was originally paid for an asset plus the value of certain improvements. Every asset of an estate has a basis. Basis is important because when an asset, such as a house, is sold, and assuming there is a profit, the difference between the sale price and the basis (usually the original purchase price) is assessed a capital gains tax (2011 Capital Gains rate – 15%). Thus a profit of $100,000 would owe $15,000 in capital gains tax and a state income tax if applicable.

However, the Estate Tax laws as written in 2001 provided for a very important and useful benefit in terms of basis – All assets within a decedent’s estate would automatically get a step up in basis at the date of death to the fair market value. What does that mean? Simply – For tax purposes, the basis of the asset would “step-up” from the original basis to the value of the asset at the time of the decedents death. This means that were the executor or beneficiary to sell the asset shortly after the decedent’s passing, they would owe no or very little capital gains or state income taxes because the difference between the basis and sale price would be zero, or close to it.

 

2010 Decedent’s Implications Regarding Step Up in Basis:

The applicable law in 2010 stated that there would be no Estate Tax assessed for individuals passing in the year 2010. Superficially, one would think this would be, and please excuse me, a great year to die. However, those step up in basis benefits described above are intertwined with the Estate Tax. Take away the Estate Tax, and you also lose all step up in basis benefits for assets in the estate.

The question then becomes a calculation of which option is more beneficial for the decedents estate – Paying an estate tax and getting a step up in basis, or paying no estate tax and paying capital gains and possibly state income tax in the future.

Please note, that there are also exemptions for estate’s choosing to “Opt Out” in 2010 – These exemptions are described in IRC Section 1022, and are commonly referred to as “Modified Carryover Basis” rules. In short, the exemptions allow for up to $1,300,000 in adjustments to basis for assets passing to a non-spousal beneficiary, and $3,000,000 in adjustments for assets passing to a surviving spouse. These figures can be combined for a surviving spouse, thus a total of $4,300,000 is available for adjustments to the basis of assets passing to a surviving spouse of a decedent passing in 2010.

 

Which Option is Best?

Deciding which option is best is not a simple tax-saving calculation. Obviously, if an estate is valued under $5,000,000 – you would generally opt to use the Estate Tax regime from 2011 as you will receive a full step up in basis and there will be no tax due as it is under the $5,000,000 exemption amount. Additionally, since the 2011 Estate Tax rules make the exemption “portable” to the surviving spouse, any unused portion of the exemption can be ported over to the surviving spouse in order to increase their exemption amount.

However, for estates valued at over $5,000,000, there is more to analyze.

 

Choosing to utilize the Estate Tax:

First there is the straight forward calculation of the estate tax due (35%) of the excess after the $5,000,000 exemption amount is deducted. For an estate valued at $8 million, this would be 35% (x) $3,000,000, or $1,050,000. (Note – This amount would be due exactly 9 months after the date of death, in cash)

The benefit in this utilizing the Estate Tax is that although there is a sizeable amount of tax due, all assets in the estate will receive a step up in basis. This would be useful if the assets have a particularly low basis as future sales of such assets could lead to a significant capital gains and possibly state income tax liability.

Please note that the nature in which the decedent held the property is critical in analyzing whether or not the asset qualifies for a step-up in basis. Generally, assets held as Community Property (as in California) will receive a 100% step up in basis even though the decedent is technically only a 50% owner (With the surviving spouse being the other 50% owner) – This is a huge benefit for community property states and holding title as community property. If the asset is held in joint tenancy, or a tenancy in common, only the percentage of your ownership right will receive a step up in basis.

 

Choosing to Opt Out of the Estate Tax:

Here, the $8,000,000 estate will owe no estate tax and all assets will pass to the beneficiaries free of tax liability.

However, the assets will not receive a step up in basis and the “Modified Carryover Basis” rules will apply – Meaning a $1.3 Million basis adjustment is available for estate assets passing to a non-spousal beneficiary, and an additional $3 Million for assets passing to a spouse.

If the $8 Million estate belonged to a spouse with all assets passing to the surviving spouse, up to $4.3 Million of basis adjustment would be allowed. For example, if the assets of the estate consisted of 2 houses, each of which were valued at $4 Million at the date of death, with an initial basis of $500,000 each, the total basis of the assets would be $1 Million, with the market value at the date of death being $8 Million. So there would be a $7 Million amount in unrealized profit. $4.3 Million (the maximum) would be applied to adjust the basis from $1 Million to $5.3 Million. This would then leave $2.7 Million in unrealized profit.

If both properties were to be sold shortly after the decedent’s passing, capital gains tax (15%) would be due on $2.7 Million, including any potential state income tax. The 15% capital gains tax on $2.7 Million is $405,000. The state income tax (California at 9.3%) would be 9.3% of the 2.7 Million, which is an additional $251,100. Thus the total tax liability would be $656,100.

Please note, this is assuming that the property is sold immediately after the decedent’s passing – If the property were to remain in the possession of the beneficiary and be sold in the future, there could be a possibility of an increased market value, and with it an increased capital gains and state income tax liability.

This is why it is important to understand the beneficiary’s intentions with the estate assets, as their specific needs will determine the best course of action.

 

Conclusion:

As you can see, choosing between the 2011 Estate Tax regime and Opting Out is not a simple decision, as several numerical and non-numerical factors will ultimately decide what the best course of action will be for each specific situation. Therefore it is important for the surviving spouse to conduct a thorough analysis with both immediate and future potential tax liabilities in mind.

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