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Estate Tax: What You Need to Know for 2010

Even though estate taxes lapse for one year, the temporary change will not necessarily make taxes lower or simpler for some inheritors of large estates in 2010.

Congress was expected to renew the estate tax in the closing days of 2009, but the U.S. Senate failed to pass the bill, making 2010 the first year without an estate tax since 1916. The estate tax lapses for one year. It will return next year, likely with lower exemptions and higher rates than in 2009.

The lapse in the estate tax will not affect the vast majority of families. Estates worth less than $3.5 million were exempt from estate taxes in 2009, and less than 2 percent of taxpayers who die each year typically pass on larger estates. However, some inheritors of substantial estates could get a major tax break. For others, capital gains taxes could simply replace or even exceed estate taxes.

The main reason is a technical change in cost-basis calculations for capital gains taxes on inherited property. Normally, capital gains taxes are paid on cost-basis profits. If an investor buys a stock for $10 and sells the stock when it is worth $100, she pays capital gains taxes on the $90 profit.

Last year, if she had kept the stock and passed it to her heirs, the inheritors could have sold the stock without paying capital gains on the $90 profits. Instead, the heirs would pay a bulk estate tax on the full inheritance (assuming it was above the $3.5 million exemption).

For 2010 inheritances, the heirs will have to pay capital gains taxes on increases from the cost basis, which was $10 in the example above.

As with estate taxes, there are exemptions for the new capital gains rule. The heirs in our example could receive assets of up to $1.3 million without paying capital gains taxes on the basis increases. A surviving spouse can take an additional $3 million exemption.

However, heirs with larger estates could face heavy taxes, as well as the logistical headache of trying to find the cost basis of every asset, including adjustments for stock splits and other changes.

A separate Generation-Skipping Transfer tax also lapses for one year. The GST tax, levied on estates that directly descend from a grandparent to grandchild, has the same exemptions but higher tax rates than the estate tax. However, the gift tax remains in place for gifts greater than $13,000 that cumulatively total more than $1 million.

Note that none of the changes affect 2009 inheritances, so do not apply these changes to tax filings this month. Also keep in mind that the law changes again in 2011. The estate tax will likely return at a 55-percent rate for all estates worth more than $1 million.