From the July 2009 issue of Wealth Manager Web • Subscribe!

Watch Your Step-Up

Over the past few months, we've pondered the fate of the tax package authorized by President Bush and a bi-partisan Congress in 2001. The big question, of course, revolves around the fate of the estate tax, scheduled to die in 2010 and then be resurrected--at its prepackage figures of a mere $1 million exemption and a top rate of 55% on property exceeding that amount. And while we wait for Congress to get around to deciding whether to allow this to happen or to intervene, estate planners and wealth managers are trapped in a quagmire.

But there are other areas affected by the Bush tax reforms that also remain in limbo without congressional intervention.

Mr. Bush and Congress engaged in more legislative legerdemain when they created a "twilight zone" for the special break authorized by Internal Revenue Code Section 1014 for inherited assets. These assets generally are stepped-up in basis from their original cost to their value on the date of the previous owner's death. For heirs, that means forgiveness of capital gains taxes on pre-inheritance appreciation and, on subsequent sales, tax liability based only on post-inheritance appreciation.

But starting in 2010--the year the estate tax officially comes to an end--a cap kicks in on the amount of inherited assets qualifying for a step-up in basis. Under this restriction, there is a step-up just for the first $1.3 million of property, although it rises to $3 million for property that goes to a surviving spouse.

In the event there is no extension of estate tax repeal, the current step-up system resumes in 2011. But between now and 2011, there might be further revision or even an elimination of the ceiling on the step-up. In the meantime, ceiling detractors maintain that it would introduce costly complexity. President Obama's advisors say he wants to retain the current rules. Meanwhile, stay tuned.

Many wealth managers and estate planners are advising clients coping with greatly diminished asset values to make lifetime transfers of stocks and other kinds of property. Gifts from parents to children, grandchildren and other family members reduce the value of assets subject to potential estate taxes upon death. With values low, making gifts now ensures that clients' estates will not include more expensive assets--and costly estate tax bills--down the road.

An example: Grandparents give their grandchildren shares of Last National Bank, whose share price once peaked at $100 and then nose-dived to its current $10. Those shares probably have nowhere to go but up. If they do, the post-transfer appreciation will escape the estate tax.

There are alternatives to gifts. One is to pass property to heirs through the owners' estates. However, many seniors are rethinking decisions to hold on to appreciated assets until they die. While there is a stepped-up basis for inherited assets, there also is a historically low current rate for capital gains. Through 2010--at least for now--the top rate for most long-term capital gains is 15%, and it drops to 0% for anyone in the bottom tax brackets of 15% and 10%. Retirees might well reason that they ought to sell selected holdings now, before they die, rather than fixate on how the step-up would benefit their heirs. This tactic especially commends itself to those whose fixed-return income from interest, pensions and Social Security is insufficient to cover increasing living expenses--including medical care--and who have significant portfolios.

Here's how the step-up helps heirs realize big savings on capital gains taxes. Say Aunt Amelia writes a will leaving appreciated stocks to her nephew Norman. When Norman receives his inheritance and sells the shares, the sale receives distinctive treatment under Code Section 1014. The basis for the shares gets stepped-up from their original cost to their value on the day Amelia died. (In certain cases, Amelia's executor has the option to use the property's value six months after the date of death.) Consequently, Norman never pays capital gains taxes on the amount the stocks appreciated while they were owned by Amelia, and neither does she or her estate. Not until Norman sells does any tax become due and, even then, it is levied on post-inheritance appreciation only.

For example: Amelia originally paid $50,000 for shares worth $300,000 at her death. As her heir, Norman subsequently sells them for $400,000. Because Norman's basis was stepped-up to $300,000, the amount he declares as profit is only $100,000--the increase in value between the time his benefactor dies and the time he unloads the stock. Norman dodges capital gains taxes on the $250,000 the stock increased between the time of Amelia's original purchase and her death. Her purchase price is irrelevant.

Holding period for inherited assets
Another advantage for Norman is that his $100,000 gain is long term. This holds true even if he sells the shares only a few days after Amelia's death, because Code Section 1223(9) treats property received by an heir from a decedent as if it were held for more than one year.

Rates for capital gains and ordinary income
Norman's filing status and his income-tax bracket determine how much he pays in capital gains taxes on the $100,000. There are six brackets--10%, 15%, 25%, 28%, 33% and 35%-- that change continuously because they are indexed, that is, automatically adjusted each year to reflect inflation.

For 2009 and 2010, the top rate for most long-term capital gains is 15% for individuals in the four top income tax brackets of 25% through 35%. It is 0% (5% before 2008) for those in the two bottom brackets of 15% and 10%. For 2009, the amount that separates the 15% bracket from the 25% bracket is taxable income of $33,960 for single filers and $67,900 for joint filers. Taxable income means the amount remaining after reportable income is reduced by exemptions, deductions and other subtractions.

As the law now stands, when 2010 ends, the maximum capital gains tax rates of 15% and 0% are supposed to "sunset," restoring rates of 20% for individuals in brackets of 25% and higher, and 10% for those in the 10% and 15% brackets--as they were before enactment of the Bush tax package. But that will not come to pass if our lawmakers cut a deal to extend the rates of 15% and 0% into 2011 and beyond.

On the campaign trail, candidate Obama proposed increases from 15% to 20% to the top rates for long-term capital gains on stocks, bonds and most other assets and qualified dividends for individuals in the two top tax brackets. The proposal was adjusted to affect only families with incomes above $250,000 and individuals with incomes over $200,000. (Although he didn't make clear the criteria used to arrive at those figures, he did make clear his commitment to making permanent Mr. Bush's tax cuts for families with annual incomes under $250,000 and single households with annual incomes under $200,000.) He has been equally adamant about his support for repeal of tax cuts for people in the two top income tax brackets.

In May, President Obama's staffers announced that the proposal affects only families with taxable income above about $230,000 and single households with taxable income above about $190,000.

In any case, Mr. Obama's position on the top rate for dividends is that it should continue to be far less than the top rate for ordinary income. Therefore, investors in the 10% and 15% brackets would still be taxed at 0% on long-term capital gains and dividends.

Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners. Information about his books can be found at

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