As Congress begins discussion on proposed changes to the tax code, there are often small points that take a while to attract the public’s attention. One of those is the proposed elimination of the federal estate tax.
By current law, estates under $5.49 million are not subject to estate taxes. With a bit of planning, a married couple can have $10.98 million of an estate shielded from estate taxes. The current law pegs the taxable level to inflation, so the amount subject to tax will move with the economy.
One point to remember in calculating estates taxes is that taxes are applied on the net estate, not the gross estate. An individual with $7 million in assets but also with $2 million in debt has a net estate of $5 million, none subject to federal estate taxes.
The American farmer has quite often been the poster child for efforts to eliminate the estate taxes. But very few farm families are subject to the estate tax while far more benefit from an aspect of the law that is usually not mentioned when discussing how people might benefit.
This aspect is the step-up in basis, which helps all individuals whether they are subject to estate taxes or not. This particularly benefits those who invest in business assets that are generally held a long time and slowly increase in value over time. Sounds like farm land? Perfect example!
So what is this step-up in basis? It is part of the estate tax code. At the time of death, assets are distributed by will or through a trust as directed by the individual and valued at current market value. You may inherit some farmland, cows or a valuable antique or stamp collection.
What is the tax situation? If the estate was valued under $5.49 million, there is no federal estate tax on the estate.
But what about the individual who inherited the property? It works like this. You inherit 100 cows valued at $1,600 per cow, totaling $160,000. You do not owe taxes unless you sell them above the new basis.
What is the basis? At the time of death, all assets are valued by a reputable appraiser that puts the current value of the cows at $1,600 each at the time of the owner’s death. So that is the cows’ new basis, no matter whether their basis was $0 or $1,200. The person who inherited the property can sell the cows for any amount up to $160,000 and pay nothing in capital gains tax. If they sell the cows for $161,000, they pay capital gains tax on the $1,000 made over the basis.
How about land, generally the highest value farm asset? Here is where farmers see a huge impact. Let’s say your parents bought a farm 30 years ago for $50,000. It can’t be depreciated, so book value remains at $50,000. Today the farm is worth $800,000. The farmer dies owning the farm. After taking an inventory of all assets and paying off debts, the farmer’s estate is worth $3 million. It’s not subject to estate taxes, so there is no worry for the farm family to sell the farm to pay estate taxes.
What is the heir’s tax situation? The farmer leaves the farm to his daughter who has worked with her parents for years. She now owns the farm that now has a tax basis of $800,000. She can sell the land for $800,000 and not pay one penny in capital gains tax. Nothing. No capital gains tax on sale of the farm.
Now let’s assume the estate tax is eliminated and with it, the step up in basis. The farm is now valued at $800,000 but has a tax basis of $50,000 due to losing the step up in basis. The daughter does not have any children who are planning to take over the farm. She is getting chronic aches and pains that come from farming and decides to retire. The daughter has an offer of $800,000 and decides to sell the farm.
The capital gains tax works like this. Sales price less the basis = taxable capital gain. Her sales price was $800,000 and a basis of $50,000. Taxable capital gains = $800,000 – 50,000 = $750,000. Capital gains tax runs 15 to 20 percent depending on the individual. The daughter now faces capital gains tax of at least $112,500 or as much as $150,000 — all due to elimination of the federal estate tax.
This is what could happen if the estate tax is eliminated. The contrast is quite clear.
— People with estates over $5.49 million will not have to worry about estate taxes.
— Everyone with estates under $5.49 million will not have to worry about estate taxes, but they didn’t have this worry before.
— Everyone loses the step up in basis.
Who gains and who loses? Depending on your opinion, that’s debatable. But when you hear about the disadvantages of the estate tax, don’t forget that the free step-up in basis gives a huge benefit to families not subject to subject to estate taxes. The step-up in basis also benefits those who pay estate taxes.
So be cautious when you hear debates on the estate tax because you rarely hear about elimination of the step-up in basis, which can benefit farmers as well as people who inherit a valuable antique or stamp collection.
Note that the figures in this article are just examples. Always check with a tax professional on your specific situation. This example does not relate to the Vermont Estate Tax.
Bob Parsons is an agriculture economist at UVM Extension. Contact him at email@example.com or 656-2109.