On January 1, 2010 the federal estate tax will end, and transfers made upon death will be taxed using the concepts of "carryover basis" and "basis adjustment."

The new tax concept is outlined in 26 USC §1022, called "Treatment of property acquired from a decedent dying after December 31, 2009." There will be two types of "basis adjustments" that will save most estates from paying federal taxes on assets transferred upon death, and then sold at a profit by your estate or your heirs:

• §1022(b): a $1.3 million aggregate basis increase for each individual person, and
• §1022(c): an additional $3 million spousal property basis increase for property that is transferred upon death to a surviving spouse.

This will mean a free pass, with no death transfer tax, for most estates. Also, the $1.3 million basis adjustment will be increased by any unused capital losses, net operating losses and other "built-in" losses of the decedent.

Your estate will also be able to use the Principal Residence Exclusion to shelter any gain on the sale of your home. This will open up new opportunities for planning, and more flexibility for planning transactions with real estate brokers and real estate professionals.

Here are a series of questions and answers on the new law:

Q. How will this tax be assessed and reported? Answer: The allocation of the aggregate basis increase will be made by the executor on each asset, and reported on a "Basis return." All assets of the decedent (whether or not they are part of an estate processed through Probate Court) will be part of the calculation. The report is required if all property acquired from the decedent exceeds the $1.3 million aggregate adjustment. §6018
Q. What assets are eligible for the adjustments?Answer:Property owned by the decedent at time of his or her death. §1022(d)(1)(A)
Q. How wIll Jointly held property be taxed?Answer: The decedent shall be treated as the owner to the extent of the value of a fractional part to be determined by dividing:
the value of the property
by the number of joint tenants who have right of survivorship.§1022(d)(1)(B) (i)(III)
Q. What About Revocable Trusts? Answer: The decedent shall be treated as owning property transferred by the decedent during life to a qualified revocable trust (as defined in section 645 (b)(1)). See §1022(d)(1)(B)(ii)
Q. Will Recently Gifted Assets be Part of the Estate? Answer: No. The basis increase does not apply to property acquired by the decedent by gift or by inter vivos transfer for less than adequate and full consideration in money or money’s worth during the 3-year period ending on the date of the decedent’s death. §1022(d)(1)(C)(i). But there is an Important Exception for Married Couples! Subsection (i) does not apply, unless, during the 3-year period, the spouse who transfers the asset to his/her spouse had acquired the property in whole or in part by gift or by inter vivos transfer for less than adequate and full consideration in money or money’s worth. §1022(d)(1)(C)(ii)
Q. What About IRA's and other Income in Respect of a Decedent? Answer: Basis increase does not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691. Retirement plans and other IRD will not be eligible for the allocation of step-up basis. IRA's will be taxed as "ordinary income," not capital gains. §1022(f).
Q. Will Life Insurance Proceeds Need an Adjustment in Basis? : Life insurance will retain its long standing tax-privileged status under the new adjusted basis regime. The income tax exclusion for life insurance proceeds is untouched. No need to allocate any of the decedent's carryover basis adjustments to life insurance.
Q. Can people get around the "carry over" basis rules by loading up on debt?: There will be recognition of gain if a loss exceeds the adjusted basis. §1001.
Q. Is the spousal adjustment of $3 million in addition to the aggregate basis adjustment of $1 million? Yes. In addition to the aggregate basis increase, the spouse gets another $3 million adjustment. The adjustment is allowed only for property passing to a surviving spouse outright or in a qualified terminable interest property "QTIP" trust.

The spousal exception to the 3 year rule against gifts could be used by one spouse to transfer an asset with a low basis to an ill spouse, who could then leave the asset by bequest, devise or inheritance to the surviving spouse with an increased basis!
The spouse could then sell the asset for FMV without recognizing any federal capital gains tax. This concept may become known as "basis laundering" for married couples.

Q. What about the Principal Residence? In 2009, an amendment to §121(d) will extend the principal residence exclusion to a home sold by:
(A) the estate of a decedent
(B) any individual who acquired such property from the decedent (within the meaning of section 1022), and
(C) a trust which, immediately before the death of the decedent, was a qualified revocable trust. The exclusion will be "determined by taking into account the ownership and use by the decedent." See my article on the principal residence exclusion.
Q. What about Life Estates, for Parents who Have Transferred Remainder Ownership of the Homes to their Children? If we look at §1014(f), we see that Section 1014, the section allowing the step up in basis, "shall not apply with respect to decedents dying after December 31, 2009." So, where a life estate/remainder interest has been used to avoid probate and protect a home from Medicaid liens, the children will not be able to sell the home on a tax-free basis when the parent dies! It is possible that Congress might vote to reinstate the basis step - up for the value of a life estate remainder, but you cannot be sure about that!

Conclusion: As the law stands now, everything reverts to the old step-up rules in 2011. But Congress will certainly act to prevent that from happening, so that dramatically different taxation amounts will not result for people who happen to die in one year rather than the next. These wild swings in estate tax and income tax laws make it more important than ever to have an estate plan that protects you, and maximizes your ability to care for your loved ones.

The $1.3-million step-up in basis will eliminate any capital gains taxation for most estates. Estate tax planning will be simplified for people who do plan ahead. That gives financial planners, bank officers, stock brokers, and real estate professionals the opportunity to emphasize and focus on the many non-tax estate planning issues that really matter to most people:

• Planning for disposition of assets and providing for survivors, without estate taxes confusing the decision making;
• Business succession planning;
• Asset protection using business entities for non tax purposes;
• Planning for a disabled child;
• Planning to maintain maximum independence, and for care in case of incapacity.

We can help you put together a plan that will take all these issues into account, and set your mind at ease.