Estate Taxes

The federal estate tax has been repealed for 2010. That's good news for high-net-worth individuals and their heirs, right? Well, sort of.

Depending on the wording of your will or trust, the lapse of the estate tax could have a variety of unintended negative consequences. The issues are complex, so be sure to consult a tax attorney if you believe you might be affected.

Also, the estate tax is scheduled to return in 2011 with a $1 million exemption at a rate of 55% (only assets in excess of that amount are subject to the tax), compared to the $3.5 million exemption that was in effect for 2009 with a top rate of 45%.

The situation is fluid, however, and could change significantly before the end of the year. Many experts expected Congress to act before the end of 2009 to prevent the estate tax from lapsing in 2010. That didn't happen, but Congress could pass a measure this year and make it retroactive to Jan. 1, 2010. Whether the retroactive provision would survive a court challenge, however, is an open question.

The Obama Administration supports the retroactive plan and is proposing reinstatement of the 2009 exemption levels for 2010 and beyond. If the Administration's proposal is not enacted, a provision currently in place that hasn't gotten much recognition could spell tax trouble for some heirs.

When the estate tax was in force, heirs would figure their investment cost basis on assets such as stock or real estate at their value at the time of inheritance, not when they were originally purchased. That can make a major tax difference when heirs sell the assets and realize a capital gain.

But if the repeal of the estate tax stands, the stepped-up basis treatment will be limited to the first $1.3 million in capital gains pertaining to inherited assets. The limit is $3 million for assets transferred to a surviving spouse. Anything above those levels is valued at the original basis that the deceased paid for the assets. Note: The provision limits the stepped-up basis valuation of appreciated assets that are part of an estate only for those individuals who pass away in 2010.

Possible strategies: If there was ever a reason to work with a professional in preparing an estate plan, this is it. Because of the range of variables and the high stakes involved for wealthy individuals, consulting a trusted estate planner is the best strategy for anyone who might be subject to either the estate tax or the limitation on stepped-up basis treatment.

Should the estate tax not be reinstated for 2010—and depending on the health status of your parent or spouse--you might want to begin tracking down any investment documents that will help your heirs determine the original cost basis of any assets they stand to inherit, and make sure they are stored in a safe place.