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Federal Estate Tax Update--Inheriting Property in 2010

Currently, there is no estate or generation-skipping transfer (GST) tax for 2010, but both taxes are scheduled to be reinstated in 2011, with a $1 million estate tax exemption, a GST tax exemption of about $1,340,000, and a top rate of 55%. The federal gift tax, however, remains in effect for 2010, with a $1 million lifetime exemption and a top rate of 35%. Of course, it's still possible that we'll see legislative action in the next few months. For example, Congress could extend 2009 rates and exemption amounts (the result would be a $3.5 million exemption amount for both estate and GST taxes and a top rate of 45%). It's impossible to predict specific action, however, or whether any such action will be applied retroactively to 2010.

Current 2010 rules

While the joke may be that this is a good year to die, in reality, it's not that simple. True, there's no federal estate tax--at least for the moment--but the rules that now apply in 2010 change the way inherited property is taxed--in a way that's not always favorable. This means that some individuals who inherit property in 2010 may be in for a surprise when they sell the inherited assets. It's all because of a change in the way cost basis is calculated for property inherited as a result of a death.

New cost basis rules for 2010

What's cost basis? The cost basis of an asset is generally its purchase price, and it's used to calculate taxable gain (or loss) when the asset is sold. For example, if you own a share of stock, your cost basis is generally the purchase price plus any costs incurred in the purchase (e.g., any commissions). With real property, your cost basis is increased if you make capital improvements.

Prior to 2010, the cost basis of any asset you inherited was generally "stepped up" (or "stepped down") to what the asset was worth (its fair market value) on the day that the person who left you the property passed away. So, for example, if you inherited a piece of property worth $100,000, that property would generally have a basis of $100,000, even if the person who passed away had purchased the property for $10,000. If you sold the property years later for $115,000, any taxes due would be based on $15,000 gain ($115,000 minus $100,000).

If you inherit property as a result of a death in 2010, however, this step-up rule doesn't apply. Instead, your basis in the inherited property is the lower of the property's fair market value as of the date of death or the deceased owner's cost basis. In the example above, that means that your basis in the property would be $10,000, resulting in a $105,000 gain if you sold it for $115,000.

There are two very important exceptions. First, every estate gets a $1.3 million increase in basis that can be allocated among assets (up to fair market value) by the executor of the estate, increased by unused built-in losses and loss carryovers. Second, there is generally an additional $3 million increase in basis available for assets (also up to fair market value) passing to a surviving spouse, either outright or through a qualified terminable interest property (QTIP) trust (but only $60,000 basis increase for nonresident alien decedents). This means the basis of assets in an estate with a surviving spouse as a beneficiary can potentially be increased up to $4.3 million.

So, if the appreciation of assets in the estate is $1.3 million or less (or $4.3 million for a surviving spouse), then the basis of those assets can be increased to fair market value as of the date of death. This means if you inherit an asset in 2010 with its basis stepped up to fair market value, and you sell that asset for no more than its date-of-death fair market value, you'd realize no tax on the sale.