As of January 1, 2010, the federal estate tax has been repealed for estates of people dying this year. While that may seem like good news for the beneficiaries of your estate, there are potentially negative consequences of the repeal. First, many estate planning documents are drafted based on the assumption that there will be an estate tax in place, and are therefore structured to pass as much wealth as possible to beneficiaries free of the tax. For example, in 2009 when $3.5 million worth of assets were exempt from estate tax, an amount equal to the exemption would be passed to non-spouse beneficiaries (using what’s known as a credit shelter trust), and the remaining assets to the surviving spouse. However, if the first spouse were to die this year, there is a risk that all assets would pass to the credit shelter trust, potentially leaving the surviving spouse with nothing.

Second, beneficiaries will now be subjected to capital gains liability that did not exist when the estate tax was in effect. Before the repeal, heirs received a “step-up” in their cost basis for inherited assets to the value of that asset on the deceased’s date of death, meaning that they wouldn’t be responsible for paying capital gains on the amount that the asset appreciated during the original owner’s lifetime. Now that the estate tax has been repealed, the step-up has been eliminated and replaced with new “carryover basis” rules which require heirs to use the price originally paid when determining capital gains. In addition to the record-keeping problems created by having to track how much was paid for the asset, the full amount of appreciation will be taxed to the beneficiaries as capital gains when the asset is sold. Fortunately, there is some relief for beneficiaries, since up to $1.3 million in capital gains is exempt from tax (and an additional $3 million is exempt if the beneficiary is a spouse).

Though the estate tax has disappeared for now, there is still a possibility that Congress will act to reinstate the tax retroactively for 2010. And even if the tax is not reinstated this year, it is scheduled to come back as of January 1, 2011, with only $1 million in assets exempt and the excess taxed at a rate of up to 55%.