Estate Tax is Dead (Not Really)

After years of debate, Congress passed legislation that will gradually repeal the estate tax by 2010 for one year only.  The estate will however return in 2011 with a vengeance and an exemption of only $1 million (i.e., substantially less than the current exemption of $1.5 million).

In 2001, after ten years of debate, Congress passed legislation  repeals the federal estate tax, a tax imposed on the assets left at death. The full repeal, however, won't take place until 2010  and its is only a one year repeal.  In 2011, the estate tax will come back unless Congress votes to extend the repeal (most commentators believe this is unlikely due to the size of the current budget deficit). Meanwhile, though, estate tax rates will go down and exemptions will go up.

What's Next for Estate and Gift Tax

In 2004, the federal estate tax affects only people who die leaving a taxable estate of more than $1.5 million. (In 2001, the figure was $675,000.) The estate tax threshold will continue to rise until 2010, when the tax will be repealed. The top tax rate (now 48%) will eventually drop to 45%. The exact dates and amounts of the changes are shown below.

Congress did not repeal the federal gift tax, although it raised the lifetime exemption and lowered the maximum tax rate. The lifetime gift tax exemption has gone up to $1 million and will stay there (unlike the estate tax exemption). That means you will be able to make a total of $1 million of taxable gifts over your lifetime before owing any federal gift tax. In addition, you can make an unlimited number of $11,000 gifts (to different recipients) of cash or other property each calendar year, completely tax-free.

How the Estate Tax Will Fade Away

If you're married, estate tax is most likely to be an issue when the second spouse dies. (When the first spouse dies, everything left to the survivor passes tax-free.) But if the second spouse owns all of the couple's property, and it's worth more than the estate tax exemption, estate tax will be due. So if you and your spouse together own more than $1.0 million (the 2011 estate tax exemption), you may still want to think about using an AB trust, making gifts during life, or using another tax-avoidance strategy.

Other Tax Changes That Affect Estate Planning

The 2001 legislation affects all kinds of taxes, not just gift and estate taxes.

Generation-skipping tax. This is an extra federal tax on transfers made from older folks to someone in their grandchildren's generation. When the estate tax is repealed in 2010, the generation-skipping tax will also disappear. Until 2010, the exemption amount will be the same as the estate tax exemption amount (shown in the table above).

Basis of inherited property. A change with far more widespread implications is the end of the "stepped-up basis" rule for inherited property. Under current law, when you inherit something, your tax basis (used to calculate taxable profit when you sell something) is the date-of-death market value of the property. So if the property's value has gone up significantly since the former owner acquired it, the basis is "stepped-up" to the date-of-death value. And that means you get a big tax break when you sell, because your taxable profit is based on the date-of-death value, not the lower basis of the former owner.

That rule will end when the estate tax does, in 2010. From then on, when you inherit property, you can choose to take a stepped-up basis for $1.3 million of it. If you inherit more than that, you’ll have to choose which assets get a stepped-up basis. For the rest, your basis will be the former owner’s basis or the date-of-death market value, whichever is smaller.