The Estate Quirk

Yesterday we mentioned that as things stand now, the estate tax is scheduled to go away for the entirety of 2010. But that doesn't mean the your heirs will be free of tax if you pass away during the next twelve months. A quirk in the capital gains tax law means they are likely to owe something anyway. Here's how it works:

In the past, estates have been taxed solely on the basis of what they were worth at the time of the decedent's passing. So if your grandfather had bought IBM at 5 in 1970, and it had risen to 100 by the time you inherited it in 2000, you would have owed estate tax on the stock at it present value of 100. But no one would have ever had to pay capital gains tax for that rise from 5 to 100.

In the absence of the estate tax in 2010, such transactions will be treated as gifts. So even though there would be no estate taxes due, there would be capital gains taxed owed on the entire appreciation of the gift, dating back to when the decedent acquired the asset. In this example, you would owe capital gains taxes on the entire 95-point appreciation in the stock.

This will have the result of subjecting more people to taxes on inherited property, not less. It will also lead to lots of scrambling through old paperwork to figure out exactly when someone bought a few shares of stock 40 or 50 years ago. Don't be surprised if horror stories arising from this situation lead Congress to finally address the estate tax again.