Estate tax for 2010 and the Modified Carryover Basis Option

The estate tax for those dying in 2010 gives you a one-time only choice of two ways to be taxed. You can either opt for a $5 million exemption and pay 35% estate tax on any excess value of your estate or you can opt for an unlimited estate tax exemption which essentially eliminates any estate tax. But the latter option comes with a carryover basis for inheritors - and that can make a big difference.

A primary difference in these two estate taxation options is the tax-basis ascribed to property that someone inherits. The tax basis of property you inherit can have considerable taxing implications when you sell.

All property - stocks, houses, whatever - has a tax basis which is the original cost of that property plus improvements (in the case of a house). When that property is sold, the seller must pay a capital gains tax on excess of the selling price (less selling expenses) over its tax basis. Selling it for less can bring a capital gains tax deductible loss.

Property that is transferred generally carries its tax basis with it - i.e. its carryover basis. But exceptions occur as I specify below.

*Option 1: The $5 million tax exemption option with its step-up basis:

If you opt for the 35% estate tax rate with its $5 million exemption, then all inherited property receive a step-up basis. That means the basis of property you inherit is changed to the fair market value it had on the date of death of the owner you inherited it from. Usually property - like a house - increases over time so its fair market value is much greater than the tax basis it had in the hands of the decedent.

If you sold that property soon after inheriting it at the same fair market value, you'd have no capital gains tax because of its stepped-up basis. That can be quite a tax savings compared to having to pay a high capital gains tax on property with no stepped-up basis and a low carryover basis.

You can see the advantage of opting for the $5 million estate tax exemption if you don't want to burden your inheritors with future capital gain taxes. Hopefully your estate tax exemption will cover most all your estate property so you want lose much or anything to the 35% estate tax rate.

Incidentally, the 'step-up' is sometimes a 'step-down' in basis. That's when the fair market value of the property on the date of the decendent's death is less than his tax basis in the property. You can consider how you'd handle the choice in this case.

*Option 2: The unlimited estate tax exemption with its modified carryover basis:

But if you have a very large estate, you may want to opt for the unlimited exemption and deal with the carryover basis for your inheritors. There is still a bit of a tax break here. And that's that the carryover basis has been modified somewhat to help reduce the future capital gains tax.

The modification of the carry over basis allows the tax basis of property passing to a beneficiary other than a surviving spouse to be increased by up to $1.3 million. But if the property goes directly to the surviving spouse or into a qualified terminal interest property trust set up to benefit the surviving spouse, then the basis can be increased an additional $3 million. That's adds up to as much as $4.3 million.

But be warned that the modified basis can never exceed the fair market value of the property at the date of death. Nevertheless, every bit of potential tax savings can help, and to the extent that the modifications help, all well and good.


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Shane Flait helps you with your financial legal, tax, and retirement goals.
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