Congressional Inaction Hits Heirs of Estates Over $1.3 million

To the surprise of just about every tax expert in Washington, lawmakers failed to address the estate tax mess before hightailing it out of town at the end of 2009. If you've been tuning out the estate tax brouhaha in D.C. on the assumption it's a rich-folk problem you don't have to sweat (the exemption in 2010 was $3.5 million), it's time to pay attention. A quirk in the 2010 law means inherited real property valued at more than $1.3 million could trigger big tax bills for beneficiaries.

The issue that grabs headlines is the main federal estate tax. In a mess created by the 2001 Bush tax cuts, the estate tax has long been scheduled to disappear in 2010 before reemerging in 2011 at its pre-2001 level: A top rate of 55 percent levied on estates above $1 million. What everyone thought would happen sometime in 2009 is that Congress would at the very least extend the 2009 terms ($3.5 million exemption) into 2010 while it considered what to do come 2011. But Congress did nothing, so for the moment the changes imposed by the 2001 tax law are in effect for 2010.

That's led to all sorts of macabre scenarios: From a tax perspective it's a great time for the uber-wealthy to die as their heirs owe no estate tax in 2010. Congress has vowed it will address the issue when it gets back to work and will make any law retroactive to January 1. But lawyers are already hitting the case law readying to challenge the constitutionality of the "retroactive" bit.

Loss of Step-Up Basis
What's not getting enough attention is that because of Washington's inaction another estate tax law kicked into action on Jan. 1, that will impact thousands of more families.

Under old law, inherited property (excluding retirement accounts) was given a stepped-up basis for tax purposes: the value of property on the date of death was considered the "cost" basis for the beneficiary. So for example, if a parent paid $500,000 for a home, and the value of the home on the date of the parent's death was $2 million, the child's cost basis was $2 million.

For 2010 the step up basis rules have changed. Just $1.3 million gets preferential step-up treatment. Above $1.3 million the beneficiary inherits the decedent's cost-basis. (Surviving spouses can step-up an additional $3 million.) That's going to create a taxing situation for thousands of moderately well-off families in 2010. And it's anyone's guess at this point whether making a fix retroactive to January 1, will stick.