Clock is Ticking on Estate Tax Sunset Rules

Year-end deadline looms or estate taxes will disappear for 2010 and bring tougher capital-gains taxes.

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Don't look now, but the federal estate tax is set to disappear in 2010 in a little more than three weeks unless Congress approves a measure to extend it. Most people expect that to happen, and the House did approve a bill late last week to create a new permanent estate tax. Under this measure, estates would have an exclusion for taxes of $3.5 million ($7 million for couples). The top tax rate for larger estates would be 45 percent. Estates also would enjoy a key provision that sets the the value of estate assets, for tax purposes, at their value when the estate holder dies, not when he or she originally acquired the assets. This spares heirs from hefty capital gains taxes on inherited assets.

[See Best Affordable Places to Retire.] Without new legislation, the sunset provisions of current estate tax rules would erase the tax entirely in 2010 and then restore it in 2011 with a 55 percent tax rate and an exclusion of only $1 million. And while Congress could always take steps in 2010 to change that 2011 scenario, it must act this year to avoid triggering the 2010 estate rules.

Losing the estate tax altogether in 2010 might seem like a good deal for estate beneficiaries. But an even larger pool of taxpayers might get an unpleasant surprise. That's because the value of assets in 2010 estates would be set, for tax purposes, at their level when they were originally acquired. In addition to being a bookkeeping nightmare, this provision would trigger capital gains taxes for any estate larger than $1.3 million. It would affect a projected 71,000 estates in 2010, according to a Joint Committee on Taxation estimate cited by a spokesperson for North Dakota democrat Earl Pomeroy, chief sponsor of the House measure.

If Congress failed to act this year, it could void the 2010 rules next year, the spokesman said, but anyone who died before the changes were made would be treated under the then existing rules for 2010 estates.

"It is unclear if the Senate will take up the House bill before year-end," according to an assessment by tax experts at CCH. "One possible scenario is that the Senate will approve the House bill by unanimous consent shortly before starting its holiday recess. One of the biggest stumbling blocks to passage in the Senate is the House’s decision not to index the $3.5 million exclusion for inflation."

[See Best Places to Retire.]

If the House bill is not debated before being approved by the Senate, it's likely the issue will be revisited. Some experts thus feel the $3.5 million, 45-percent tax approach should be regarded more as a short-term fix than a long-term policy. Compared with the stiffer tax and exclusion rules that had been set to reappear in 2011, the House bill will remove more than $230 billion in federal revenue over the next 10 years. Many people are philosophically opposed to any estate tax, noting that funds used to amass estates have already been taxed. But losing that much revenue during a period of record budget deficits will be a point of contention raised by those supporting continued estate taxation.

Very few people have estates large enough to be affected by these rules. Those fortunate enough to be among them should stay in touch with their financial advisers for further estate-tax developments.

[See 8 Tips to Avoid Nasty Estate Surprises.]