Attention, heirs: No estate tax, but watch for capital gains kicker.

The estate tax has been repealed for 2010, but heirs may find themselves owing more capital gains tax when they sell inherited assets.

Dennis Cook / AP / File
House Speaker Dennis Hastert of Ill., flanked by GOP colleagues and small-business owners, calls for the repeal of the estate tax, which they've dubbed 'the death tax,' at a Capitol Hill news conference in this file photo from June 8, 2000. In 2010, the estate tax has been repealed, thanks to Senate gridlock, but heirs who try to sell inherited property or taxes may have to pay hefty capital gains taxes.

No joke: The other day a financial planner told me about a client who asked if he could rework his father’s end-of-life advance directive to take into account the ever-changing estate tax. In other words, could he pull the plug on the old man if it looked like he was going to die before January 1, but keep him going if he lived into next year?

To his credit, the planner told his client to buzz off. But if this loving son thought he’d stand to cash in if his father died this year, he might be in for an unpleasant surprise. It is true that, thanks to Senate gridlock, the estate tax has been repealed for 2010. But that gift came accompanied by a lump of coal: Some heirs may find themselves owing lots more capital gains tax when they sell inherited assets.

Here’s the problem. Until this year, an heir could take advantage of what’s known as stepped-up basis on inherited property. In other words, capital gains taxes would be based on the value of an asset at the time the owner died, rather than what he originally paid for it. Say Uncle Harry bought some stock for $1,000. When Harry passed away and left his shares to his nephew Jack, they were worth $5,000. Under 2009 law, the basis of that stock would be stepped up to $5,000. Thus, if Jack sold the stock for $5,000, he’d owe no capital gains tax.

But as a trade-off for what lawmakers presumed would be a repealed estate tax, heirs this year face a very different set of rules, known as carry-over basis. Now, they will have to pay capital gains tax on the difference between their sale price and the asset’s value when the decedent acquired it. In other words, Jack would have a taxable gain of $4,000 and, at this year’s 15 percent capital gains rate, owe tax of $600. Plus, he’ll have the more-than-annoying chore of trying to figure out what Uncle Harry actually paid for his shares, especially if Harry reinvested dividends or the stock split over the years.

The actual rules are a bit more complicated. Executors have the right to step-up basis by as much as $1.3 million (plus another $3 million for a surviving spouse) and there are some other exceptions, but the general rule applies. Thus, some heirs will owe a lot more capital gains tax on property they inherit this year. Many, in fact, were better off in 2009, when they enjoyed a $3.5 million exemption from the estate tax plus got the benefit of stepped-up basis.

There are two important implications of this: The first is that while it is true that estates of billionaires such as George Steinbrenner could pass to heirs tax-free this year, those heirs may end up owing more capital gains taxes. Of course, nobody is worried much about the Steinbrenner heirs. But taxpayers who inherit small businesses, many of which have a very low basis, may be hit hardest by this.

Here’s what happens: Say Uncle Harry built his business with sweat equity. His company was worth $3 million when he died, but its tax basis was zero. Jack inherits the firm and sells it right away. If Harry died in 2009, there would be no tax (since Harry’s estate was worth less than $3.5 million it owed no estate tax, and thanks to stepped-up basis Jack owed no capital gains tax). But under 2010 rules, Jack would owe $255,000 ($3 million less the $1.3 million in allowed step-up leaves $1.7 million in gains taxed at 15 percent).

You may have heard some cryptic talk from Congress about allowing executors the option of using either 2009 or 2010 estate tax rules for those who die this year. Lawmakers have not been very clear about what that is all about. Now you know.

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