On June 7, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001, a $1.35 trillion tax-cut plan. Among other things, this act provides for a phased-in repeal of the estate tax with a full repeal in 2010.
During the phase-in period, the unified credit exemption from the federal estate tax will be increased from $1 million in 2002 to $3.5 million in 2009. The current rules providing for a stepped-up (or stepped-down) basis for property acquired from a decedent also will be repealed. These rules will be replaced by a carry-over basis regime whereby property received from a decedent will have a basis equal to the lesser of the adjusted basis of the decedent or fair market value on the date of death.
This tax law change may have a dramatic effect on highly leveraged real estate, resulting in the replacement of the estate tax with a capital gains tax imposed on the estate and possibly the beneficiaries.
Present Law on Estate Taxes
Under present law, the unified estate and gift tax rates begin at 18 percent on the first $10,000 of cumulative taxable transfers and reach 55 percent on cumulative taxable transfers greater than $3 million. In addition, a 5 percent surtax is imposed on cumulative taxable transfers between $10 million and $17.2 million, which effectively phases out the benefit of the graduated rates. Thus, these high-end estates are subject to a top marginal rate of 60 percent. Estates greater than $17.2 million are subject to a flat rate of 55 percent on all amounts exceeding the unified credit effective exemption amount, as the benefit of the graduated rates has been phased out. The taxable estate is comprised of the gross value of the decedent's estate, less certain deductions. Among the deductions are mortgages and other indebtedness with respect to property included in the gross estate.
Another important component of the estate tax for beneficiaries is the basis of the property received. In general, gain or loss, if any, on the disposition of property is measured by the taxpayer's amount realized, or gross proceeds received, on the disposition, less the taxpayer's basis in such property. Basis generally is calculated as the taxpayer's investment in property with certain adjustments required after acquisition. For example, basis is increased by the cost of capital improvements made to the property and decreased by depreciation deductions taken with respect to the property.
Under existing law, the property passing from a decedent's estate generally would take a stepped-up basis, which is defined as the fair market value on the date of the decedent's death or, if the alternate valuation date is elected, the earlier of six months after the owner's death or the date the property is sold or distributed by the estate. This step up (or step down) in basis allows the beneficiary to avoid capital gains tax on any appreciation of the property that occurred prior to the owner's death and eliminates the tax benefit from any unrealized loss. This increase in the basis of the property also permits the estate to avoid a capital gains tax related to the distribution of the appreciated property to the beneficiary.
Impact of the New Law
The phased-in repeal of the estate tax will begin in 2002, with a full repeal effective in 2010. In 2002, the unified credit exemption amount will be increased to $1 million for two years and gradually raised until it reaches $3.5 million in 2009. Moreover, the act gradually will reduce estate tax rates, leading up to full repeal in 2010. In 2002, the 5 percent surtax (which phases out the lower rates) will be repealed and the maximum rate will be reduced to 50 percent. From 2003 through 2007, the maximum rate will be reduced 1 percent per year until it reaches 45 percent.
Throughout the phase-in period, the stepped-up basis rule will continue to apply; so an estate still will avoid the capital gains tax on the distribution of appreciated property, and heirs will be able to dispose of property without recognizing any gain on appreciation that occurred during a decedent's life.
Beginning in 2010, the current law that provides a fair market value basis for property acquired from the decedent will be modified. Under the general rules in 2010, a modified carry-over basis regime generally will take effect. The heirs will inherit property with a basis equal to the lesser of the adjusted basis of the property in the hands of the decedent or the fair market value of the property on the date of the decedent's death.
Impact on Real Estate Owners
While the repeal of the estate tax generally will be beneficial to estates with valuations in excess of the unified credit exemption amount, it will not be cost free to certain estates and beneficiaries. Estates holding highly leveraged, low-basis real property will be subject to a capital gains tax that would not have been imposed prior to the repeal. In addition, a beneficiary may be subject to greater capital gains tax at the time of disposition of inherited property.
With respect to the estate, a capital gain would be recognized upon the distribution of the real property and the assumption of the accompanying liability to the extent that the liability exceeds the estate's basis in the property.
The impact of the estate tax repeal is contrasted with existing law in the following example.
Assume a decedent owned real property valuing $6 million, with an adjusted basis of $2 million and subject to a non-recourse liability of $4 million. Until the full repeal in 2010, the basis of the property could be increased to the fair market value of $6 million in exchange for the estate tax. As a result, the estate does not recognize a capital gain in connection with the distribution of the property to the heir since the basis would exceed the $4 million amount realized from the heir's assumption of the debt. In addition, the heir receives a $6 million basis in the property and could dispose of the asset without recognizing a capital gain.
Under the carry-over basis regime effective with the repeal, the basis of the property would remain unchanged at $2 million, resulting in a $2 million capital gain for the estate when it distributes the property, subject to the liability, to the heir. The estate would have an amount realized of $4 million and a basis of only $2 million. Furthermore, the heir would take a $4 million basis in the property (a carry-over of the $2 million basis of the decedent plus the $2 million gain recognized by the estate), so subsequent disposition of the property for its current fair market value of $6 million would result in an additional $2 million capital gain that would not exist under current law.
Consult a tax professional for further information.