The 2010 Bush tax cut extension legislation also established a favorable, but temporary, federal estate and gift tax regime for 2011 and 2012. But we will go back to the bad old days on Jan. 1, 2013, unless Congress takes action and the president goes along.
Here's what you need to know, starting with where we stand right now.
Snapshot of the Current Rules
$5.12 Million Exemption and Flat 35% Tax Rate
For estates of individuals who die in 2012, the federal estate tax exemption is $5.12 million, and so is the lifetime federal gift tax exemption (up from $5 million for 2011). The estate tax rate on the taxable value of an estate in excess of the exemption is a flat 35%, as is the gift tax rate on lifetime gifts in excess of the exemption (same rate as for 2011).
Deceased Spouse's Unused Exemption Is Portable
The unused unified federal estate and gift tax exemption of an individual who dies in 2011 or 2012 is "portable," which means it can be passed along to the surviving spouse. The portable exemption provision, in conjunction with the longstanding unlimited marital deduction provision, means the first spouse to die can leave everything to the surviving spouse without any federal estate tax hit (assuming the surviving spouse is a U.S. citizen and is therefore eligible for the unlimited marital deduction). If the first spouse dies in 2012, the surviving spouse will then have two $5.12 million exemptions to work with, for a total of $10.24 million -- assuming the surviving spouse also dies in 2012.
Important Point: Before the portable exemption deal, it was often necessary to take tax planning steps like: (1) transferring assets between the spouses while they were both still alive in order to equalize their respective estates or to make sure each spouse's estate was worth at least the estate tax exemption amount; and (2) setting up credit shelter trusts to make sure the estate tax exemptions of both spouses were taken advantage of without shortchanging the surviving spouse. Such steps are a pain and they might become necessary again in 2013 and beyond, depending on what happens with the estate and gift rules.
Unlimited Basis Step-Up for Inherited Assets
For heirs of individuals who die after 2010, the familiar rule that allows the federal income tax basis of inherited capital-gain assets (such as real estate and stock) to be stepped up to reflect the date-of-death fair market value has been reinstated. That means heirs won't owe any federal capital gains taxes on asset appreciation that occurs through the date of death -- as long as that date is after 2010. The good news: this taxpayer-friendly rule is not scheduled to disappear at the end of 2012 (it's permanent, unless Congress changes its mind which has been known to happen).
Taxmageddon Scheduled for 2013
The current estate and gift tax rules are as taxpayer-friendly as anyone could have reasonably hoped for, but most of the good stuff is only locked in for 2011 and 2012. Expect estate and gift taxes to become major bones of contention during the lead-up to the Nov. 6 general election. What happens in 2013 and after will probably depend on how the election turns out.
If nothing gets done on the estate and gift tax front, we will automatically go back to the unfriendly regime that was in effect before the Bush tax cuts were enacted. That would mean a paltry $1 million unified estate and gift tax exemption (versus $5.12 million under the current rules) and a whopping maximum estate and gift tax rate of 55% (versus 35% under the current rules). In addition, the portable exemption privilege would become history.
At this point, it's unclear what will happen, but I can foresee at least four possibilities.
Bad Old Rules Return as Scheduled: This is a possibility if the Democrats retain the Senate and the Presidency and retake the House.
Existing Favorable Rules Are Extended: This is a good possibility if the Republicans seize the Senate and the Presidency.
Estate and Gift Taxes Are Completely Repealed: This is a possibility if the Republicans win the Senate and the Presidency, but it is less likely than an extension of the current rules.
Pretty Good 2009 Rules Return: In 2009, we had a $3.5 million estate tax exemption, a $1 million gift tax exemption, and a 45% maximum estate and gift tax rate. If the November election results in a mixed outcome, returning to the 2009 rules might be a compromise that both Democrats and Republicans could swallow.
Dealing with Uncertainty
Sadly, we will probably not know the estate and gift tax situation for 2013 until several weeks into the lame duck Congressional session that will convene after Nov. 6. If you have a good-sized estate, be prepared for an emergency year-end meeting with your professional adviser to react to whatever happens -- or doesn't happen.