Ok, so this tax seemed to be getting an awful lot of bad press lately. Certain VERY Wealthy Think Tanks have been doing their best to get you to believe that this tax is unfair and needs to be abolished. But does it really?
First, you need to understand exactly who and how this tax is calculated. I’m going to be throwing a lot of numbers at you to help show how this works so try to stick with me. Now I admit, when I was younger and not doing this for a living, I thought this was a horrible tax too, but then I learned how it worked.
The Estate Tax, intentionally misnamed the Death Tax by it’s opponents, only affects about 0.2% of the population. Most American’s (and their heirs) will NEVER, EVER pay this tax so long as the current exemption limit stays where it is at. In December 2010, President Obama signed the “Unemployment Insurance Reauthorization and Job Creation Act” which permanently (well, permanently until congress changes it) set the Personal Estate Tax Exclusion amount to $5,450,000 if the taxpayer is Single or $10,900,000 if married. When a spouse passes, the spouses exemption can pass to the surviving spouse allowing the surviving spouse to take the entire $10.9M exemption in his/her estate upon their passing.
So how does this work then? Ok… let’s say you are a single person with 1 child (this is also an important piece). You own a house which you bought for $25,000 (it was your childhood home). When you passed, your home was worth $200,000. You also had the following additional assets: Stocks worth $1,000,000 (which you paid $100,000 over your lifetime); Land purchased for $50,000 now has a Fair Market Value (FMV) of $2,000,000.
When her final tax return is completed, her Assets are Revalued at the FMV at the Date of Death. In this example, this person’s Assets are valued at $3,200,000 with a cost of $175,000 – not too bad right. Her assets have a GAIN of $3,025,000. When her final tax return is done (form 1041) she will report $3,200,000 of Asset Value less the cost of $175,000 and the Capital Gain on those assets is $3,200,000 LESS the $5,490,000 exemption leaving NOTHING to tax for the Estate Tax. Why because the FMV of those Assets is LESS than the Exemption. Her child will inherit these assets at the FMV of those assets at the date of death and His/Her Gain on these assets (for their Final Return) starts upon their parent’s death or the date they inherited the property.
So far, this all seems fair and makes sense right. The parent never really used or touched those assets they just stayed in some account or the parent used the home and land like they have since they purchased it. Now let’s look at why the Anti-Estate tax people want to eliminate this. Simply put – because they will end up paying taxes on any Gain on those assets over the Exemption Amount (remember that’s upto $11 Million). So you’re probably saying well that’s not fair. But wait.. here’s why it’s important.
Let’s say you are an uber wealthy Real Estate developer who has Buildings all over the world. One building in particular you bought for only $500,000 but it’s now worth an FMV of $5,000,000. A couple years ago you decided you wanted the Equity from that building (Equity is defined as FMV Less any loans on that Asset). You go to the bank and take out $3,000,000 and enter into Mortgage on that building – Cash in Hand – NO TAX IMPACT ON YOUR TAX RETURN THAT YEAR but you just got $3,000,000 to spend any way you want to!! So why no tax impact? Because you still own the building and it’s a LOAN, something you contract to pay back. Unexpectedly you pass away before you pay back the loan. Now, here is why estate tax is so important. Remember this person already received the cash equity from this building, maybe even gave some to their children but NEVER paid taxes on that $3,000,000. By eliminating the Estate tax they never would pay taxes on it either!! They have literally just received $3,000,000 in FREE MONEY! Their kids could just stop paying the Mortgage and the bank takes the property… but the money, it’s gone. The Tax Code says their children inherit the Building at the $5,000,000 FMV at the date of their parent’s death. And let’s say they decide to just sell the building for $4,950,000 – which represents a LOSS on their taxes; the children would still end up with another $1,450,000 of TAX FREE MONEY because they sold the building at a loss and that free money, well that was part of their parent’s estate.
So what the Estate tax actually does is RECOGNIZE the PASSIVE INCOME (or Appreciation) that was locked up in ASSETS during the Taxpayers lifetime. Think of it as a “GAP” Tax rather than an Estate or Death Tax. As this tax catches all the Passive Earnings that you’ve never been taxed on. Most of us only get paychecks or maybe we run a small business and get Earnings from that business but that money is literally taxed every year on our tax returns. If we are among those fortunate enough to buy Investment Assets, we still get an Exemption on that value but only when we exceed that Exemption do we pay taxes on those Investments. Everyone gets the same exemption – EVERYONE GETS $5,490,000.
So, have I convinced you yet why having the Estate tax is Fairer than NOT having the estate tax? And don’t take to the argument that the money was worked for… it’s not, that money has already been taxed. This is a tax on the PASSIVE or better yet, APPRECIATION of the asset that each of us would recognize if we sold it BEFORE we passed away… only then, it’s called CAPITAL GAIN!
I hope this helps shed some light on how this tax works. I hope it helps explain how eliminating this allows only those seriously wealthy people to avoid paying taxes while the vast majority of us will pay tax on almost every dime we make.