While the transfer-tax provisions discussed so far add up to significant tax relief for wealthier taxpayers, there's more to the story. Starting in 2010- the year estate and GST taxes are repealed -taxpayers will have to begin applying another set of new rules that will, in many cases, result in higher capital gains taxes (or regular income taxes) being owed when inherited assets are sold.

The new rules center on a tax concept known as "basis." In tax parlance, the term "basis" generally refers to the amount a taxpayer pays to acquire an asset, plus or minus various adjustments that may be required after acquisition (for items such as depreciation, reinvested dividends, and the cost of capital improvements). Basis is used to measure gain or loss when an asset is sold. For example, your aunt's basis in land she purchases for $100,000 is $100,000. Her subsequent sale of the land for $500,000 would result in a $400,000 gain.
While cost is the usual starting point for figuring an asset's basis, prior to 2010 inherited assets generally receive a basis "step-up" to their fair market value at the time of death. So, for example, if land that cost $100,000 is included in your aunt's estate at its current fair market value of $500,000, the land's new basis (in the hands of the person who receives it from her estate) becomes $500,000, and a subsequent sale of the land for $650,000 would result in a gain of $150,000. Because of the basis step-up, the $400,000 of appreciation occurring before your aunt's death would not be subject to capital gains tax.

The new law's basis provisions are designed to capture income tax on pre-death appreciation when assets are sold by heirs. Starting in 2010, only limited basis step-ups will be allowed for a decedent's assets, as follows.

• Up to $1.3 million may be added to the basis of one or more assets included in the gross estate.
  
  
• An additional $3 million may be added to the basis of assets transferred to a surviving spouse.
  
  
• Estates of non-resident, non-U.S. citizens are limited to a $60,000 basis step-up.

Both the $1.3 million and the $3 million figures will be adjusted for inflation occurring after 2010. The estate's executor or personal representative will be responsible for allocating the step-up amounts among eligible estate assets.

Certain estate assets -amounts in tax-deferred retirement plans and individual retirement accounts (IRA's) that will be taxable upon distribution, for example -will not be eligible for the basis step-ups. These assets, along with any others that aren't allocated a basis step-up, will pass to heirs and beneficiaries with a "carryover" basis equal to the lesser of (I) the decedent's adjusted basis in the property or (2) the property's fair market value on the date of death.

The Impact:

Once the carryover basis system is in place, there will be no incentive to hold appreciated assets simply to obtain a basis step-up at death. While estate taxes won't be an issue, potential capital gains taxes will be a prominent planning consideration. Some families may actually be worse off after repeal if they are forced to liquidate highly appreciated assets and pay taxes immediately on gains computed without the advantage of a basis step-up.

Be aware that business owners who have buy-sell agreements will have to carefully review them as the years count down to 2010. Unlike under current law, once carryover basis is in place, the automatic sale of a business interest due to a buy-sell agreement will likely result in an immediate capital gains tax for the deceased owner's estate.

The process of settling an estate won't get any easier after 2009, as executors and personal representatives will be required to provide the IRS with new information concerning estate assets, including the basis that will carry over to the heirs. Determining carryover basis promises to be a difficult task, especially when estate assets have been owned for many years or numerous basis adjustments are required.

Additional problems may arise if an estate includes assets that were given to the decedent by a parent (or someone else) because the decedent's basis will hinge on the parent's (or other donor's) basis in the assets. Moreover, larger estates will face complicated decisions about how best to allocate the $1.3 million and, if available, the $3 million basis step-ups to estate assets that may be passing to multiple heirs.

Strategies To Consider: As estate tax repeal and the carry-over basis rules take effect, it will be important to have a plan for allocating the $1.3 million basis step-up available to all estates and, if applicable, the $3 million basis step-up for assets passing to a surviving spouse. Your plan for passing your investment portfolio and other assets to your heirs should take into account the potential income taxes your heirs may incur should they sell assets received from you.

Organize Your Records. Without appropriate records, it will be all but impossible to plan properly for the new carry-over basis rules. If you own family heirlooms, real estate, or other assets that you inherited, the values claimed on your deceased relative's estate-tax return will be the basis amounts that will carry over to your heirs. If you own property you received as a gift, records documenting the original cost of the property as well as any applicable basis adjustments will be needed. You also will want to have complete records with respect to your own asset purchases, including any stock or mutual fund shares acquired through dividend reinvestment programs. Also be sure you can document your real estate transactions, including any depreciation allowable for tax purposes.

Make Intra-family Transfers. The $1.3 million basis step- up available to all estates is a tax benefit you won't want to waste. If your parent has a small estate relative to yours, consider transferring appreciated assets to your parent so that his or her estate can eventually allocate the basis step-up to the assets before transferring them back to you. Be sure the transfer won't result in the payment of gift taxes, and note that this tax-saving strategy will be effective only if the transfer occurs more than three years before your parent's death and your parent isn't forced to use the assets to pay for health care or to satisfy other creditors. A similar strategy might be used if your spouse's estate is not large enough to utilize the basis step-up. Here, the three-year rule wouldn't apply.

Be Aware of Life Expectancy. Because the carryover basis rule won't go into effect until 2010, any gifting strategy before then needs to be carefully weighed. An older or infirm individual needs to decide whether he or she can reasonably be expected to live past 2009. If not, holding low basis assets at least equal to the applicable estate-tax effective exemption amount in the anticipation of obtaining a stepped up basis for the assets at death may be a valid strategy. Review Your Investments. You may be holding highly appreciated investments that you would like to sell if it weren't for the capital gains taxes that would be due. Your heirs may face a similar problem in the future, unless the investments they inherit from you qualify for a basis step-up in your estate. This trade-off is one you may want to consider in constructing a portfolio designed to meet your goals.

What Has Changed: Various other new transfer-tax provisions could affect your planning. Donors of gifts and executors of estates will be subject to additional reporting requirements regarding basis of assets. The income-tax exclusion for up to $250,000 of gain on the sale of a principal residence is extended to decedents, estates, qualified revocable trusts set up prior to death, and heirs, starting in 2010.