The Estate Tax Gap

While heirs of the mega-rich who die in 2010 may benefit from an estate tax break, they could actually wind up worse off due to the disappearance of the step-up in basis rule for capital gain assets.

Although inherited assets are not given an automatic step-up in basis in 2010, executors can assign up to a $1.3 million step-up basis to estate assets and an additional $3 million step-up for assets left to a surviving spouse. Consider the following example:

Son inherits from Father a home purchased for $100,000 that is now worth $2.5 million. Daughter inherits from Father stock purchased for $500,000 that is now worth $2.5 million. Both children receive assets worth $2.5 million, but Son has actually received less because he will owe more capital gains tax when he sells the house. However, Executor can choose to allocate a larger portion of the step-up in basis to Son in order to offset the inequality.

Sometimes making things equal isn’t as easy as demonstrated in this example. How to handle these situations is a question for executors who face possible lawsuits from dissatisfied heirs.

The disappearance of the step-up in basis rule has also created a record-keeping nightmare. Heirs must track things like capital improvements and stock splits over the past fifty years in order to determine what their inherited basis is.

While we anxiously await Congressional action to fix the estate tax problem, “it won’t happen fast enough to forestall some families’ estate tax hell.”  Amy Feldman, Mind the Estate Tax Gap, Business Week, April 15, 2010. 

Special thanks to Jim Hillhouse (Wealth Counsel) for bringing this to my attention.