Estate Income Tax & the Step-Up in Basis

The Internal Revenue Service taxes estates at two distinct levels; first is the total amount in the estate when the decedent passes away, minus the statutory exemption. This exemption changes from time to time, but for the tax year 2011, it is currently set at $5 million. Assets above that figure are subject to estate tax unless they go to a surviving spouse. The second component of taxation is income taxes on income realized between the time the decedent passed away and the time the estate was liquidated.

Your basis in an asset -- sometimes referred to as "cost basis," or "tax basis," is generally equivalent to the amount of money you have invested in an asset or property, including any money you spent on capital improvements, but not deductible repairs. Also, subtract from that number any deductions you took during your period of ownership for depreciation. The IRS uses your cost basis to calculate your tax liability when you sell an asset.

Under the current tax law, when you inherit property, your tax basis in the property is the fair market value of the property when the person you inherited it from died. When property appreciates, this arrangement is more favorable, because you will not be liable for capital gains taxes from appreciation enjoyed by the previous owner. You will only pay capital gains taxes on any gains from the value when you inherited the property, and then only at the time you sold it.

Congress has passed a special rule for estates of people who passed away in 2010 only. Specifically, their heirs can choose to take a step-up in cost basis on all inherited assets, under the 2011 rules, or they can elect to forgo the stepped-up basis, and not pay the estate tax at all, no matter how valuable the estate.

Generally, the goal of the probate process is to pass assets on to heirs and close out the estate's affairs as quickly as possible, consistent with the terms of the will and the operation of intestate laws. Even so, the probate process can take months or years. During this time, the estate may continue to receive royalty income, interest income from bonds or a closely held business, or payments from period-certain annuities. The estate must pay income tax on these assets. To declare and file income taxes on an estate's behalf, file an IRS Form 1041, U.S. Income Tax Return for Estates and Trusts.