Why Repeal of the NJ Estate Tax Means Married Couples Should Update Their Wills

Effective January 1, 2018, New Jersey repealed its estate tax.  The question then become how does this affect you and do you need to do anything about it?  For most people the change is a positive one because it means their heirs pay less taxes and they do not need to do anything to update their documents.

Generally, You are Unaffected by the Repeal of the NJ Estate Tax If...

1. You do not have children and plan on leaving money to siblings, nieces, nephews, friends or charity.
2. You are NOT married but have surviving descendants.
3. You are married couples with children and you plan to leave everything outright to your surviving spouse on the first to die.

In all three situations above, the repeal of the New Jersey estate tax should not affect you and you generally will not need to update your Will or Revocable Living Trust.*  In the first situation, if you are leaving money to siblings, nieces, nephews and friend, be aware that NJ did NOT repeal its inheritance tax, so you still are affected by that.

For married couples who have a Disclaimer Trust plan, your documents are also generally unaffected.

Repeal of the NJ Estate Tax Can Dramatically Affect Married Couples Who Set up a Trust for the Surviving Spouse

To understand why the repeal of the New Jersey Estate Tax can adversely affect married couples who set up a trust for the surviving spouse, I will take a step back to discuss why we often recommend a trust be created for a surviving spouse.

Reasons to Create a Trust for a Surviving Spouse

1. The first spouse to die wants to ensure that if the surviving spouse gets remarried, the children are protected from future spouse and still receive an inheritance.
2. You have children from a previous relationship and want to ensure that upon the death of your spouse, your children receive whatever is left over.
3. The surviving spouse isn't good with money and needs assistance managing the wealth.
4. Estate Tax Efficiency - Prior to 2017, New Jersey had a ‘use it or lose it’ state estate tax exemption of $675,000.  

Why Was It Tax Efficient to Create a Trust for a Surviving Spouse

Protecting money for the benefit of the your children or from a spendthrift spouse are still very valid reasons to set up a trust, so I will spend the rest of the article talking about how trusts for a surviving spouse in older Wills and Revocable Trusts are usually no longer tax efficient.  

Let's presume it's 2016 and we have a married couple with $1,350,000 of assets.  One spouse dies leaving everything to survivor outright.  The surviving spouse then dies shortly after leaving everything to the children.  In this scenario, we would lose the NJ estate tax exemption of the first spouse to die and the children would only benefit from the $675,000 NJ estate tax exemption of the Surviving Spouse.  Assuming no growth in assets, the children inherit the full $1.35M, but $675,000 would be subject to a tax of almost $55,000.

To minimize the NJ estate tax, attorneys would advise clients to set up a trust for the surviving spouse instead of having funds go outright.  So, in the example above, when one spouse dies, he could leave everything to a trust for the survivor.  The surviving spouse then dies shortly after leaving everything to the children.  In this scenario, by funding a trust for the surviving spouse, we are utilizing each spouse's NJ estate tax exemption.  Upon the death of the surviving spouse, children would receive $675,000 from the trust tax free and the other $675,000 from the surviving spouse tax free.  This type of planning could easily save $55,000 in NJ estate taxes.

Funding a Trust for the Surviving Spouse May Be Tax Inefficient after the Repeal of the NJ Estate Tax.

Now that you know why it was advisable to set up a trust for a spouse and why it was tax efficient, you need to know why most older trusts should be amended.  Basically, now we can make it even MORE tax efficient.  This time, however, we are not talking about estate tax efficiency - now we are trying to make the trusts more efficient for income tax and capital gains tax purposes.  Let me give you two examples again:

Let's presume it's 2010 and we have a married couple with $1,350,000 of assets.  Dad dies leaving everything to Mom.  Mom lives another 20 years before dying and leaving everything to the children.  Since Mom lived another 20 years, let's presume the assets grew by $1M and were now worth $2,350,000. We do not have to worry about the NJ estate tax anymore, so the assets would go to the children completely free tax.  Additionally, when the children receive their inheritance, it is eligible for a step-up in basis.  This means that the children can effectively sell their inheritance the day after Mom dies and pay no capital gains tax on the $1M+ of appreciation.  (Please read this post to better understanding basis.)  

Now, let's presume the same facts as above except that when Dad died, he left $675,000 to Mom in trust.  Let's also presume that the trust received the benefit of all the appreciation, so that when Mom died, she had $675,000 in her own name and $1,675,000 in trust.  The children would still receive a step-up in basis from the $675,000 in assets that came from Mom, but the basis in the trust fund assets would only be $675,000 (the value on Dad's date of death).  So when the children sold the assets that were in the trust, there would be a capital gains tax (up to 23%) on the $1M.  

Most older Wills and Revocable Trusts used this formula for a trust for a surviving spouse, so hopefully it is easy to see why it is no longer tax efficient to continue using it.

Do I Need to Update My Estate Planning Documents?

If you have a Will or Trust created prior to 2017 leaving money in trust to a surviving spouse, the short answer is probably yes.  The one major exception to this is if you have a Disclaimer Trust plan.  If money goes outright to the surviving spouse, and the survivor has to make an affirmative election to fund a trust, then the plan most likely is fine the way it is written.

How You Can Fix Your Older Trusts

If you have an estate plan that automatically leaves money in trust for the surviving spouse, there are two easy ways you can fix it so that it is more tax efficient. 

1. Option one is to get rid of the trust for the surviving spouse and leave everything to the survivor outright.  This is an easy solution when the estate isn't very large or complex.  However if you are in a second marriage situation or if you are concerned about the surviving spouse getting remarried or spending away the children's inheritance, then you should consider the second option.
2. Option two is to revise the formulas in the Will or Trust so that it gets a step-up in basis when the surviving spouse dies.  (There are hundreds of ways to do this which are far beyond the scope of this post.)

To further complicate things, most tax attorneys like me will also build in a fail-safe so that if the NJ estate tax comes back, we can have the option of funding an old-style trust.

Conclusion 

If you have an older Will or trust that leaves money to a surviving spouse in trust - have it looked at.

* Regardless of whether you have a trust for a surviving spouse, always have your own estate planning documents reviewed by your attorney just to be sure it matches your wishes and still complies with state law.  The purpose of this blog post is to discuss who is most likely to be affected by the repeal of the New Jersey estate tax.

NJ Estate Tax Repeal: How Does This Affect You?

It's official.  According to NJ.com, Governor Christopher Christie has signed a a bill to repeal the New Jersey Estate Tax.  The new law is part of a larger package deal that increases the gas tax, reduces the sales tax slightly, gives the working poor a larger tax credit, gives a tax cut on retirement income and gives a tax exemption for veterans who have been honorably discharged.

Under prior New Jersey law, a person may leave an unlimited amount to a spouse or charity. However, any money going to anyone else above $675,000 (the "exemption amount") is subject to an estate tax. This rule will remain in effect for the rest of 2016.  

For calendar year 2017, the estate tax exemption amount for NJ will increase to $2,000,000.  The tax rate will generally start at about 7.2% and go up to 16% on estates over $10,000,000.

There will be a full repeal of the NJ Estate Tax starting January 1, 2018.  

We have confirmed that New Jersey will NOT be repealing its inheritance tax. Accordingly, money that is left to a non-class A beneficiary will still be subject to a tax.  In other words, there will still be a tax if you leave money to anyone other than a spouse, your descendants, your ancestors or a charity upon your death.

So the big question for many might be how does this affect you.  I will break this down into 5 categories:

1) People who have prepared existing estate planning documents;
2) People with assets between $675,000 to $5,450,000 (for individuals) and married couples with assets less than $10,900,000;
3) Married couples with assets in excess of $10,900,000; 
4) Snowbirds; 
5) Widows and widowers who are the beneficiary of a credit shelter trust; and
6) People who wish to consider Medicaid planning.

1) For people who have already prepared their estate plans, most likely this will not adversely affect your plans.  However, the modification of the tax law likely gives you the opportunity to simplify your documents.  In particular, it is common practice in New Jersey to create a trust for a surviving spouse (often referred to as a Family Trust, Bypass Trust, Credit Shelter Trust or A-B Trust) to double the $675,000 exemption among spouses.  

There still may be other reasons to have a trust for a surviving spouse (such as in second marriage situations), but starting 2018, doubling the NJ exemption amount will no longer be necessary.

2) For New Jersey domiciliaries who have assets above $675,000 (the NJ estate tax exemption limit in 2016) and below the federal estate tax exemption limit ($5,450,000 for individuals and $10,900,000 for married couples in 2016), it was a common part of estate planning for a person to make deathbed gifts to minimize the NJ estate tax liability.  Once the NJ estate tax gets repealed, it will generally be much more beneficial for a person to keep all of their assets until their death rather making substantial gifts during lifetime.

Until 2018, deathbed gifting can be very tax efficient because New Jersey has an estate tax but it does not have a gift tax.  Accordingly, there is the opportunity to substantially minimize the estate tax.  The problem however, is that many people make the mistake of gifting substantially appreciated assets such as stock or real estate. You often want to keep appreciated assets until death to obtain a step-up in basis.   

So before you make a gift, you would need to weigh the potential NJ estate tax consequence of keeping an asset versus the potential capital gains tax if an asset is sold after the gift is made.

Now with the repeal of the NJ estate tax, unless a person is likely to die prior to 2018, you don't need to worry about making the calculation as to whether the NJ estate tax or the capital gains tax will be higher.  It will almost always be better to keep the asset.

3) For married couples with assets in excess of the federal estate tax exemption amount, I have read a number of studies that indicate that a couple can usually transfer wealth in a more tax efficient manner by establishing a credit shelter trust for the surviving spouse rather than relying on portability.  

There are few reasons why wealthier clients may want to continue to use traditional credit shelter trust planning.  The first is that while the estate tax exemption is portable, the generation skipping transfer tax (GST Tax) is NOT portable to a surviving spouse.  Many wealthy clients often wish to make sure the money goes not just to their children, but also to more remote descendants.

Another benefit to traditional credit shelter trust planning is that it acts as freeze for the assets inside the trust.  Specifically, let's assume that we have a married couple with exactly $10,900,000.  If we put half of those assets in trust on the first to die, then regardless of how much that goes up or down, it passes tax free on the surviving spouse's death.  So if the value of the trust goes up at faster rate than the inflation adjustment on the exemption amount, the beneficiaries are basically saving about $0.23 on the dollar because the estate tax is a 40% tax and the capital gains on the appreciation is only taxed at 23%.

While none of this planning will be different after the NJ Estate gets repealed compared to now, it makes the planning much easier to justify because right now we have a dilemma as to "HOW MUCH" we fund the credit shelter trust with.  To avoid any tax on the first to die, a credit shelter trust can only be funded with $675,000.  For some, this hardly makes it worth setting up. However, as the estate tax in NJ goes away, we no longer have this concern.

4) For snowbirds and other people who wish to avoid a "death tax", very simply, starting 2018 the tax incentive to move will be dramatically reduced.  Back in 2009, I wrote a post discussing the tax benefit of relocating to Florida.  Once the NJ estate tax gets repealed, for many it will make little difference from a tax perspective where their domicile is.

That being said, there are still significant differences between being domiciled in New Jersey vs. Florida.  After all, if you own real estate in both places, you still will need to pay property tax in both locations.  The biggest differences that people should be aware of are:

• Florida does not have a state income tax, whereas NJ does.  (Note NJ will start exempting a substantial portion of retirement income from the state income tax); 
• Florida property has homestead protection only if you are a domiciliary of Florida.  This can provide asset protection and it usually stops the property tax from increasing; and
• NJ is keeping its inheritance tax.  So if you plan to leave your assets to nieces, nephews, friends or other non-class A beneficiaries, there could be a substantial tax savings upon your death.

5) If you have a husband or wife who passed away leaving money to you in trust, come 2018 it may be beneficial to consider options for terminating the trust.  Imagine a scenario where husband dies in in 2004 leaving $675,000 in a credit shelter trust (often called a Family Trust or Bypass Trust) for his surviving spouse.  It is likely that these assets in trust have appreciated to over $1,000,000.  If these assets stay in trust until the surviving spouse's death, it will not receive another step-up in basis.  However, if the trust is terminated and assets are distributed to the surviving spouse after 2018, it could be very beneficial from a tax perspective.  

There are many caveats to this plan.  First, you would not want to terminate the trust if the first spouse to die wanted to protect the money in trust for his/her surviving children - so you would not want to terminate the trust in second marriage situations.  Second, you may not want to terminate the trust if the surviving spouse has substantial assets or debts.  It may also not be beneficial to terminate a trust if the value of the trust assets have gone down in value.  

Nevertheless, it would be advisable to consider terminating a trust to make life easier for the surviving spouse and avoid the hassle of having to file an extra income tax return for the trust. 

Please note that a trust can only be terminated if the trust allows it, so you should have the trust looked at to see if the document allows the trust to be terminated.  If the trust does not allow for termination, consider whether it should be modified under the New Jersey Uniform Trust Act.

6) While I don't do Medicaid planning, I do engage in tax planning, and tax planning just got much easier.  The problem with Medicaid planning is that there is so much bad information out in the public sphere.  

I frequently get clients with millions of dollars who want to do Medicaid planning.  They don't realize that to do this type of planning, they actually need to give away most of their assets.  This might work well with someone who has a few hundred thousand dollars.  However, the more money you have, the less sense it usually makes to do this type of planning.

For example, if you have a $500,000 IRA, stock with a basis of $100,000 and worth $400,000, and a house with a basis of $50,000 and now worth $600,000, let's talk about the tax impact of most Medicaid planning.  In order to "give away" everything to qualify for Medicaid (a total of $1.5M here), the person would have to withdraw their entire IRA, causing a federal and state income tax of over $175,000.  Additionally, the transfer of the stock and real estate now would be subject to a built in capital gains of $850,000, resulting in about another $175,000 in capital gains taxes when sold.  

All told, this planning will likely cause about $350,000 in taxes.  This does not even factor in the planning fees and the loss of opportunity to grow the IRA in a tax deferred form.  At $10,000/month in a nursing home, that is about 3 years in a nursing home.  According to the non-profit Life Happens, the average stay in a nursing home is almost 2 and half years and about 70% of the population winds up spending some time in a nursing home.  A $350,000 tax could have paid for 3 years of nursing care home... and in a non-Medicaid facility.  

Prior to the change in the estate tax law, an argument could be made that the increase in income taxes was somewhat offset by a decrease in estate taxes. Until the end of 2016, with an estate of $1.5 million, there was the potential estate tax of over $60,000.  Repeal of the estate tax obviously changes the equation.  Under the new tax law, it is generally more prudent to keep assets in your name rather than giving them away ahead of time.  So while Medicaid planning can certainly be appropriate for some, the larger your estate, the less financial sense it makes to engage in this type of planning.  

Requirement of Executors to Report Basis of Assets When Administering an Estate - FollowUp

The IRS has released new regulations that have extended the due date for filing Form 8971 to March 31, 2016.  Executors and administrators of estates that are required to file a federal Form 706 Estate Tax Return are now also required to file Form 8971 and report the basis of the assets included in the estate to the beneficiaries of the estate.

As discussed in my post on February 7, 2016, the IRS is trying to consistently tax assets for estate tax and capital gains tax purposes.  Requiring executors to supply this information to beneficiaries and the government is their attempt to better track this information.  

Additionally, there was an open question as to whether all estates had to file the Form 8971 or just those that were over the federal estate tax exemption threshold.  According to this publication from Bessemer Trust, the IRS has issued regulations that state that if you are filing a form 706 merely to elect portability, you do not also need to file form 8971. 

Thanks again to Abby Moller for bringing this to my attention 

IRS Releases Form 8971 - Executors Now Required to Report Basis of Assets When Administering Estate

For many years the IRS and beneficiaries of estates had a problem figuring out how much gain should be imposed on an inherited asset because the beneficiaries did not know the basis.  The IRS did not like the fact that frequently the value reported by an Executor was not the value reported by a beneficiary when an inherited asset was sold.   

Accordingly, the government enacted Internal Revenue Code Section 1014(f) and is requiring that any estate which is required to file an estate tax return (Form 706) also file Form 8971 (including all attached Schedule(s) A), retro-active to decedents who died after July 2015. The executor must also provide Schedule A to each beneficiary receiving assets from the estate. Both requirements must be met within 30 days after the date on which Form 706 is required to be filed with the IRS, or the date that is 30 days after the date Form 706 is filed with the IRS, whichever is earlier. 

Notice 2015-57 has made February 29, 2016 the due date for all Forms 8971 (including all attached Schedule(s) A) required to be filed with the IRS after July 31, 2015, and before February 29, 2016. Penalties may be imposed for failure to comply with this new filing requirement.

If an estate is not required to file a Form 706, then there is no corresponding requirement to file a Form 8971.  However, it is probably good practice for the executor to advise the beneficiaries of the value of assets as determined on a decedent's date of death so that everyone knows what the new basis is in the inherited assets. 

Instructions for Form 8971 can be found here: https://www.irs.gov/instructions/i8971/ch01.html

I note that there are a number of important items that are not clear:
1)  Does Form 8971 need to be filed when an estate files Form 706 for purposes of porting the DSUE of a deceased spouse. Accordingly, until we receive clarification, it would probably be best practice to do so.

2) Which beneficiaries should actually receive a copy of the Form?  For example, it would make sense to give the form to the beneficiaries of a trust.  It would make more sense to give it to the trustee of a trust.

3) Form 8971 asks "Did this asset increase the estate tax liability?"  I am a little unclear on what this actually means.  I would think that you should pretty much always answer yes to this question.  However, I have heard one commentator state that this really muddies the waters because theoretically assets that qualify for the Marital Deduction, Charitable Deduction, or other similar deductions do not increase the estate tax liability.  Nevertheless, I do not believe the IRS now saying we don't get a step up in basis for those assets.  I believe this is primarily to identify non-qualified preferred stock options and potentially negative value assets.  After all, it would be shocking for the IRS to say that assets passing to a spouse do not receive a step up under the normal 1014 basis rules.  If I here otherwise, I will be sure to let you know... and join in the revolt against the politicians!

4) What about situations where a beneficiary is actually allowed to have a basis higher than a decedent's date of death value?  Examples of this potentially include:  situations where a beneficiary gifted away an asset within one (1) year of death, where a decedent dies owning an interest in a partnership or limited liability company subject to a debt, or real estate subject to a non-recourse debt. 

The American Bar Association Taxation Section has submitted a letter to the IRS requesting clarification of many of these items.  I hope we will all hear a response soon.

-----------
Updated 3/23/16 - Thanks to Abby Moller for finding a few typos in this article. Additionally, she has advised me that apparently you do not need to file Form 8971 just for purposes of portability.  I will try to find additional support for this.

Step-Up in Basis Rule - Common Mistakes

When a person sells property, that person has to pay a tax on the gain from the sale. Gain is determined by subtracting the sales price of the object from the basis of such object. For example, if I sold a stock for $100 and the basis was $40, the gain would be $60.

The basis of an object is generally the price a person has paid for it. However, if you pay money to improve the object (such as buying an addition onto a house), the basis will increase. If you depreciate an object for tax purposes, the basis will decrease. To more on the basics of basis, see my post: Understanding Basis.

Notwithstanding the crazy rules for an individual who may have passed in 2010, Section 1014 of the Internal Revenue Code states that if a person holds property at the time of his or her death, it will receive a new basis equal to the fair market value of such property at the person's date of death. This is known as the Step-up In Basis Rule because in almost all circumstances, the fair market value of the assets owned by a decedent is greater than the basis of in the decedent's hands just before he or she died.

However, the Step-up In Basis Rule is really more accurately called the Fair-Market Value Date of Death because, especially in this economy, there is a chance that the date of death value is less than the basis just before death. So the first mistake many people make is in not selling assets before they pass on which they can take a loss. If you bought stock for $20,000 and now it is only worth $10,000, consider selling it. If you sell it before you die, you can take the tax loss, if you keep it until you die, your heirs cannot claim that tax benefit.

If you are an executor or an elder law practitioner, you should also be aware that you have the option of valuing all assets under Section 2032 alternate valuation date. The alternate valuation date is six months following the date of death. So let's say on the date of death the assets are worth $5,500,000 and six months following the date of death they are worth $5,000,000. Unless there is a state estate tax, you may be better off using the alternate valuation date so that the beneficiaries have a higher basis in the property, even if there is a small federal estate tax. On the other hand, if, six months after the date of death, the assets are worth more, you are not permitted to use the 2032 elections.*  (See 2032(c).) The second common mistake made by many is to not wait the six months and run the calculations for both scenarios.

So, if the beneficiaries of a descendant's property get to take appreciated property with a step up in basis, why don't people just transfer their property to a sick relative and then have them bequeath it back them when the sick relative dies. Well, unfortunately, this rarely works. Often times, it can result in a gift tax, inheritance tax or estate tax. Additionally, under Section 1014(e), if you receive a property by gift, you have to hold it for one year before your heirs can get the benefit of the step-up in basis rule. This is the third common mistake. When doing an estate administration, many practitioners and accountants fail to adequately track the basis of the assets.

*Updated on 5/5/14.  Thanks to Bob Derber for pointing out that I also made a common mistake!

So, Will there be a Federal Estate Tax in 2010?

On December 3, the House of Representatives passed a bill to permanently extend the Federal Estate Tax Exemption (H.R. 4154). The current exemption is $3.5 Million per person, or $7 Million for a couple, with a 45% tax on the decedent's assets over the exemption amount.

As of yesterday though, the Senate has yet to act, which means that the law passed by President Bush in 2001 remains in effect. If Senate does not pass bill to deal with this by New Year's, that will mean that on January 1, 2010 there will be no federal estate tax - maybe.

Why do I say maybe? Because it is still very likely that Congress will act after the new year to reinstate the tax, and make it retroactive to January 1st. They've done it before, with the permission of the Supreme Court. (see U.S. v. Carlton)

Even more troubling, the repeal would only be for one year, and then the exemption amount would come crashing back down to One Million Dollars (indexed for inflation) in 2011. This does not make for easy planning and will most adversely affect individuals who have children from one relationship and are now married to a different person. People who are in this situation should seek out an estate planning attorney immediately because it is likely the formulas in their Wills may cause a disastrous result. Many formulas can be read so that either the children from the prior relationship are completely cut out or the new spouse is completely cut out. There is an easy fix to this by setting caps on how much a spouse or child can get, but I reiterate - many old formulas will not work.

Most estate planning practitioners that I know still strongly believe that the government will pass a law to keep some form of estate tax - mainly because we find it hard to believe that the government will give up so much money from the people who can most easily afford to pay it. However, for those of you who have been completely ignoring the issue, it is time to start paying attention because a complete repeal of the federal estate tax will actually have a large capital gains tax consequence.

To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of "Basis". If the federal estate tax is indeed repealed, executors will be entitled, for an individual decedent, to allocate to the decedent's assets up to $1.3 million in basis plus the sum of the decedent's unused capital loss carryovers, net operating loss carryovers and unrealized losses on property owned at the date of death (IRC Section 1022(b)). No asset may be increased in excess of fair market value though.

In addition to the $1.3 million basis increase available to all beneficiaries of an estate, the executor may allocate another $3 million of basis to assets passing to a surviving spouse. (This benefit only applies to heterosexual couples.)

As a practical matter, the repeal of the estate tax will most negatively affect those few individuals who have a lot of highly appreciated assets and those individuals who might not have had to file a return at all. The reason that it negatively affects the people who might not otherwise had to file a return is because I believe that a return will have to be filed to properly allocate basis to your assets. This will result in extra attorney fees for many.

The pessimist in me says that the government will wait until about August of 2010 or so and make a retroactive law, making estate planning and administration most cumbersome and costly.

Understanding Basis

If you want to sell an asset, particularly a valuable asset, no one should do so without first understanding what the tax consequences of that sale might be. The tax that most often affects the sale of a valuable asset (in a non-business setting), is the capital gains tax. To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of "Basis".

An asset's basis is often referred to as the amount an asset cost when you buy it. For example, if you buy stock at $20 and sell it at $100, the basis of the stock is $20 and the gain on the sale is $80. If the stock was held for an appropriate time amount, the gain would be considered capital gain and taxed at the capital gains tax rate.

Now, the basis in an asset can change for a variety of reasons. For example, let's say that the stock that you bought split, you would have to split the basis in the stock in the same way that the stock split. Additionally, let's say the asset is a house, or some other type of depreciable asset. Every time you depreciate the asset, the basis is reduced. If, on the other hand, you make capital improvements to the asset, like putting an addition on to a house, that increases the basis of the asset.

So, let's assume that you buy a rental property for $200,000. You spend $100,000 improving it, depreciate it by $80,000, and then ultimately sell it for $750,000. The basis in the property would be $220,000 ($200,000 + $100,000 - $80,000). The gain would be $530,000, and most likely taxed at the capital gains rate of 15%.

Another major factor in determining the basis in property is whether, under current law, a person holds that asset at the time of his or her death. Currently, when a person dies, the heirs take the assets of the decedent with a basis equal to fair market value. (Often times this is called a step up in basis - but that is a bit of a misnomer as the basis can actually be lower in a bad economy.)

So for example, let's say that Dad dies owning a house that he purchased for $350,000, and at the time of his death it is worth $550,000. If the heirs sell the house shortly after his death for $560,000, there is only $10,000 of gain, not $210,000 of gain because of the increase in basis due to Dad's death.

Now let's complicate matters. Dad and Mom own that same property that they bought for $350,000. Dad dies when the value of the property is $400,000 and Mom dies when the value is worth $550,000. The basis in the property will be determined by whom the property was left to. If Mom inherited the property from Dad and then died, the basis of the property is the full $550,000.

If Dad left the property to daughter, and the other half the property went to daughter when Mom died, the basis will be split. The basis will be $475,000 in the hands of daughter. (1/2 of the property with a $200,000 basis as a result of Dad's death and 1/2 of the property with a $275,000 basis as a result of Mom's death.)

I emphasized "under current law" earlier because that may all change on January 1, 2010. In 2001, President Bush passed a law that eliminates the federal estate tax and eliminates the fair market date of death basis rule. There will be another form of capital gains tax exemption that will go into affect that I review in another post.

Lost in the debate over the estate tax is the importance of the rule revaluing property so that it takes on a date of death basis. One of the big problems that people have is keeping proper records of the basis of their assets. Sometimes, assets can be passed down for generations before they are sold. If the owner cannot provide proof of an assets basis, the government will assume the basis is Zero, causing a potentially very large tax.

So while keeping track of the basis of your assets was always important, it may be even more important to safeguard your paperwork pertaining to your valuables if the estate tax is truly repealed.