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A Once-In-A-Lifetime Estate Tax Choice

If a family member died last year, you can take advantage of a unique estate tax planning opportunity. You could use the estate tax provisions in place before passage of the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010 last December. Or you may employ the revised rules of the new law. Making the right choice could result in big tax savings.

Under a 2001 tax law, the estate tax was eliminated for 2010 only. Yet while that should be an obvious advantage for the estates of those who died that year, there’s a catch. Before 2010, people who inherited stocks or similar assets got a break on capital gains, because the cost basis of such assets, for tax purposes, was “stepped up” to the assets’ value at the death of the person making the bequest. But for assets inherited in 2010, inheritors must use the original cost basis, adjusted by two exceptions:

·         The basis of assets transferred to a surviving spouse may be increased by $3 million.

·         The basis of assets transferred to any beneficiary may be increased by $1.3 million.

Suppose a son or daughter inherits stocks worth $4 million that have a cost basis of $1 million. Under the original rules for 2010, the new cost basis would be $2.3 million—$1 million plus $1.3 million. (Because surviving spouses get to add together both breaks, they wouldn’t be hurt by the rule change in this example.)

The new estate rules established by the 2010 Tax Relief Act let inheritors exclude $5 million from estate tax, and the top tax rate for assets exceeding that exemption is 35%. Those provisions, in effect for 2011 and 2012, are accompanied by a return to the rules providing a full step-up in basis for inherited assets. 

The new tax law actually lets you choose which rules will govern an inheritance from someone who died in 2010. You can opt for no estate tax and the more restrictive rules on the cost basis of inherited assets, or you can retroactively apply the new rules.

Which is more advantageous? Suppose your father died in 2010 and you inherited his estate consisting of $6 million in assets with an original basis of $2 million. After deducting the $5 million exemption, you owe estate tax of $350,000 under the new rules (35% of $1 million). But the assets’ basis is stepped up to $6 million, and you won’t owe capital gains tax if you sell them for that price.

And under the old rules? You’d pay no estate tax, but you’d owe $405,000 in tax on the capital gains. The cost basis would be $3.3 million—the original $2 million plus the $1.3 million increase—leaving you with a gain of $2.7 million taxed at 35%. So in this case, you’d save $55,000 by choosing the new rules.

But every situation is different. We can work with you and your attorney to determine the best approach for your family.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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