Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

CONGRESS REPEALS DEATH TAX(?)--PART II
(6/24/01)

As I mentioned last week, Congress recently passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Tax Relief Act) which affects almost all taxpayers in one way or another. One change I mentioned was the manner in which the IRS will look at capital gains on inherited property.

Capital Gains Rules for 2001 and after

Let me retread some old ground. Essentially, the automatic "step up" in basis at death is going, going, gone. Effective January 1, 2010, inherited property will pass to the beneficiary at the lesser of its carry-over basis or fair market value at death, subject to two exceptions: (1) you can increase the basis of inherited property by up to $1.3 million, and (2) you can increase the basis of property transferred to a surviving spouse or a QTIP trust by an additional $3 million. These dollar amounts will be adjusted for inflation after 2010, but until then the $1.3 million and $3 million dollar allowable amounts will remain unchanged.

There are some qualifying tests that have to be met to qualify even for these limited step-ups in basis. For example, it will not apply to assets the decedent (1) acquired within three years of death (2) for less than full consideration (3) unless the gifts are from decedent's spouse. This test is meant to keep taxpayers from manipulating the basis of property. Otherwise, if you knew your husband was close to death, you could have property transferred to him and then have him will it back to you so you could obtain the stepped-up basis.

Is there anything we can do now to minimize the negative effects of this change?

Between now and January 1, 2010, you should be able to come up with creative ways to benefit from the current step-up rules. If, for example, your wife is likely to predecease you, you might want to put all your highly appreciated assets in her name and retain those assets which have not grown in value in your name.

If there isn't any reason to assume one spouse will die before the other, or if you just want to ensure half of the capital gains will be forgiven, you may want keep all your property and assets in a joint revocable trust with equal shares of each asset allocated to each spouse.

But what if my wife and I already have individual revocable trusts? What then?

No problem. If you already have separate trusts, have the trusts hold all your assets as tenants in common. This has exactly the same effect and prevents you from having to redo your estate planning documents.

The new law also effects the use of Qualified Terminable Interest Property (QTIP) Trusts. While I don't have the space or time to explain QTIP trusts, suffice it to say that under the old law and for some time still under the new law, we can use them to take advantage of the unlimited marital deduction. Assuming the federal estate tax remains repealed, these same instruments will take on a new role. They will allow you to take advantage of the $3 million basis step-up for property transferred to your spouse, while protecting the assets for your ultimate beneficiaries, such as your children.

Of course, we can't forget the "sunset" provisions in the newly enacted legislation. As I explained last week, all these wondrous changes go away in 2011 unless Congress passes a new law. If Congress fails to enact a new law, we will be thrown back into the law as we know it and all bets will be off.

If you try to reconfigure your assets to take advantage of the new rules and then the law is repealed in 2011, all your work may have been for naught--or worse. It could actually backfire on you since the optimum treatment of assets under the two sets of rules are at odds with one another. Let me try to explain what I mean. If the step up in basis remains repealed, you will want to allocate your highly appreciated assets to the spouse most likely to die first. If the law reverts to the pre-2001 law, you will want to allocate your assets between you and your spouse to minimize estate taxes. You can't have it both ways, so what do you do? Heads you lose, tails the IRS wins. Congress and the President have really sold us a bill of goods and it doesn't come with instructions.

Oh, there is one other rule you need to know about. Many of you in the military are married to nonresidents who are not citizens of the United States. These nonresidents are treated differently for estate tax purposes. The step up in basis for them is limited to $60,000, rather than $1.3 million. That can have a significant impact on your estate planning.

One piece of good news is that the $250,000 exclusion on gain from the sale of a personal residence remains in place and it is available to an estate or trust that sells a home so long as the sale would have qualified for exclusion had it been the decedent who sold the home.

Have there been any changes in the Gift Tax rules?

Funny you should ask. Yes, there have been changes to the federal gift tax rules. First, unlike the estate tax, the gift tax doesn't go away in 2010. Instead, on January 1, 2002, the gift tax exemption is increased to $1 million and that is where it will stay.

The different treatment of gifts and inheritances should give you pause. Annual gifts of $10,000 per person plus any additional gifts up to $1 million will merely reduce your federal estate tax exemption. Gifts in excess of those amounts will create immediate tax--they will not reduce your federal estate tax exemption.

This limitation on gifts is designed to keep you from making large gifts to those in lower income tax brackets, but for the life of me I can't see the logic of it. Why should it matter whether you give your wealth away while you are alive or leave it to your beneficiaries after you're gone. Be that as it may, this is the law and you need to be aware of it when revising your estate plans.

Next week, I'll continue this edifying discussion of the recent changes in federal tax law.

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