What’s So Good About Eliminating Federal Estate Tax?

Many of us didn’t think we’d see 2010 but I guess we were wrong. I’m not talking about any apocalyptic predictions of the end of the world but, rather, about the elimination of federal estate tax under the 2001 tax bill that President Bush signed into law. Elimination of any tax is a good thing, right? Well, maybe not, because what the government gives with one hand, it usually takes back with the other. And that is certainly the case here.

What hasn’t been talked about much is that the same law that wipes away estate tax also has eliminated the step up in basis. If, for example, you inherited at your dad’s death his house or stocks that he held for many years, the basis for calculating capital gains tax was not what he paid but the value of the assets at the date of his death. So, if you sold those assets shortly after his death you owed no capital gains tax.

Now, however, there is no step up in basis. Instead, the first $1.3 million in capital gains will be excluded from tax ($3 million for assets transferred to a surviving spouse). More Americans will pay this new capital gains tax, however, than will avoid estate tax. That’s because with a $3.5 million exemption last year most Americans never would have paid any federal estate tax. It is estimated that 6000 estates will avoid estate tax in 2010 that would have paid tax based on the 2009 exemption. However, 71,000 estates could face a capital gains tax. Very simply, wiping out estate tax benefits the wealthy. Needing to offset the loss of tax revenue, Congress has instead imposed a new tax on less wealthy Americans.

Congress attempted to amend the law to make the $3.5 million exemption permanent but couldn’t get it done before the end of year. Talk of passing this amendment in 2010 raises other issues about whether Congress can role the clock back and apply the law retroactively. And for many states, New Jersey and New York included, there is still a state estate tax to contend with. Finally, the elimination of federal estate tax is for this year only. Without further changes, the estate tax comes back next year on estates over $1 million. So for most Americans, at best, they won’t feel any effect from the elimination of a tax they never needed to concern themselves with in the first place. At worst, they face a new capital gains tax they wouldn’t have had to pay under the previous law. Just another tax bite for the average American.