Lost in Estate Tax Debate: Repeal Would Boost Heirs' Capital Gains Bills - TheStreet

If you are among the small percentage of taxpayers who will leave behind enough assets to be subject to the estate tax, you're probably heartened by growing sentiment in

Congress

to repeal the so-called "death tax."

On June 9, the

House

voted 279-136 to phase out the estate tax by Dec. 31, 2009. The measure faces uncertain prospects in the

Senate

, and in any case,

President Clinton

has threatened to veto it. Still, the idea, overwhelmingly backed by

Republicans

, has enough

Democratic

support to ensure it will be back, even if it fails this year.

But lost in the debate that has focused on the "fairness" of estate taxes is an essential point: Someone will pay tax on inherited assets, no matter what happens. Currently, the estate pays the taxes. If estate taxes are repealed, heirs will owe capital gains taxes when they sell their inherited assets.

For heirs, that sounds like a good deal on its face. Capital gains taxes max out at 20%, while estate taxes can be as high as 55%. But the repeal of the estate tax will have the effect of boosting capital gains taxes on inherited assets. And it could make these gains enormously difficult to compute. Here's why:

Currently, an estate gets a lifetime unified gift and estate tax credit of $675,000. So for a married couple, an estate can be worth $1.35 million before it's subject to taxes. (The credit will gradually rise to $1 million for individuals, $2 million for couples, by 2006.)

Assets above the $675,000 cutoff are subject to estate taxes on their fair-market value. The rates are graduated, like the ordinary income tax rates, but at much higher levels. Assuming you used up the exclusion before you died, on the low end, the tax is 18% on estates worth up to $10,000. On the high end, the rate pops to 55% on estates worth $3 million or more. Ordinary income tax rates range from 15% to 39.6%.

Currently, heirs inherit assets at their fair market value. In other words, it doesn't matter if you bought your house for $75,000 in 1962 and it's worth $4 million when you die. After the estate tax is paid, your heirs' cost basis is "stepped up" to the value of the house on the day you die, regardless of its original cost. So if your heirs immediately sell the house for $4 million, they'll owe no capital gains taxes.

But while the House voted to do away with the estate tax, it also removed this stepped-up basis at death.

Under the system approved by the House, the cost basis on amounts over $1.3 million is "carried over" from the original purchase. So in this case, if your heirs sell that house for $4 million, they'll owe capital gains taxes on $2,625,000 -- the sales price, less the $1.3 million exclusion, minus the original purchase price of $75,000.

It's fairly easy to determine the cost basis on a house. But what if you inherited stock from great-aunt Milly? When you sell that inherited stock, you'll owe capital gains tax on the difference between its market value on the day of the sale (minus the exclusion) and Aunt Milly's

original

purchase price. But what's Aunt Milly's cost basis? For assets held for decades, it could be a nightmare to find out.

"We've had carried-over basis in the law twice before, once in the '20s and once in the '70s. Both times it was repealed because of the complexity," says Clint Stretch, director of tax policy at

Deloitte & Touche

in Washington.

Under the current system, "death generally cures the problem because you get the step-up," says Sandy Schlesinger, chairman of the wills and estates department at

Kaye Scholer Fierman Hays & Handler

, a New York law firm.

Putting the complexity issue aside, the estate tax repeal will be a cost savings for the relatively few taxpayers who have to worry about it. In the example above, estate taxes on the $4 million house would amount to roughly $2 million, while in the absence of an estate tax, the capital gains bill would amount to $525,000.

For most people, this debate over estate taxes is academic. Fewer than 1.9% of the 2.3 million people who died in 1997 had to pay any estate tax, according to the

Center on Budget and Policy Priorities

, a nonpartisan research organization in Washington. And going forward, the

Joint Committee on Taxation

projects that 98 of every 100 people who die won't have to pay estate taxes.

Still, some changes to the current system are needed. For instance, if an estate don't have the available cash, it must sell assets to pay the bill. That's a big problem for farmers and small-business owners who want to pass those assets on to future generations.

If the current estate tax repeal measure is vetoed, a proposal by Rep. Charlie Rangel (D., NY) may be the next starting point. Rangel proposes to drop the top estate tax rate to 44% on amounts above $3 million, increase the gift and estate tax credit to $1,150,000 for individuals after 2005 and provide targeted relief to farmers and small business owners.

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