The NY Times has an article about the upcoming expiration of the estate tax, with this interesting nugget:

There is yet another wrinkle. When they scheduled the demise of the estate tax for 2009, the authors of the 2001 tax measure replaced it with a capital gains tax of 15 percent on inherited property that is later sold.

The threshold for being subject to those taxes is set lower, with the first $1.3 million in capital gains exempted for general heirs and $3 million for spouses. Democrats argue that thousands of estates that would not have been subject to taxes under the current law could get hit in 2010 even as those at the higher end of inheritance scale escape the 45 percent tax bite.

“If you are rich, celebrate,” said Senator Harry Reid, Democrat of Nevada and the majority leader. “If you are not, you should be afraid.”

Republicans note that the capital gains tax will be levied only if heirs sell the assets, providing incentive for families to hold on to their farms and businesses.

“As between paying 45 percent and 15 percent, I think it is pretty clear what most small business folks and farmers would like to do,” said Senator Jon Kyl, Republican of Arizona and a longtime foe of the estate tax.

Somehow, I was completely unaware of this capital gains tax stopgap. Of course Republicans can’t talk about this subject without deceiving you, as Kyl does above. Here’s what I mean: if you die in 2009, you don’t pay any estate taxes on the first $3.5 million of assets you own. If you die in 2010 (at least under present law) you won’t pay any estate taxes at all. But here’s the catch: before 2010, any property your heirs inherit from you gets a basis (a determination of value for the purposes of taxation) of the value of the property at the time that it’s passed on. So, if you own a piece of property valued at $5 million, you’re heirs would get a basis in it at that amount. Why is that important? Because when they sell that property later, capital gains taxes will be calculated on that “stepped-up” basis, which means they’re really only being taxed on the value the property has gained while it’s been theirs.  What’s different about 2010? Well, any property your heirs inherit from you gets the basis that you had in the property at your death, a basis that will be calculated at the amount you paid for the property when you bought it. So let’s say you bought a house in 1975 for $500,000, and that house constitutes the bulk of the value of your estate. $500,000, the amount you paid for it, is your basis, but in 2010 that’s also the basis your heirs will take in the property. What that means is that if they try to turn around and sell that property after your death, and that property is now worth $2 million, they’re going to end up paying capital gains taxes on $700,000, the value of the property beyond the $1.3 million capital gains tax exemption. Whereas under the 2009 conditions, they’d pay next to nothing if they turned around and sold it in the same year (whatever value the property gained between the time at which they inherited and the time at which they sold) and you, the dead person, would’ve paid no estate taxes at all because your estate falls below the exemption amount. And also importantly, you, the dead guy, would’ve paid those taxes out of your estate, instead of your heirs who are now suddenly on the hook for roughly $100,000 in capital gains taxes if they try to sell your property.  So next to no tax obligation in 2009, vs. taxes on $700,000 worth of property in 2010. That’s what Kyl refers to as “incentive.” Never mind that I’m not entirely sure why it’s a good thing that we encourage people to hold onto property they don’t want or need or can’t maintain (and especially never mind his trope about small businesses and farms, few of which the estate tax applied to even with lower exemption amounts.)

Anyway, it’s not looking like the Senate is going to pass any stop-gap measure before the New Year, hence the talk of a retroactive application for 2010. I think we can still predict that some measure of the estate tax will be instituted for 2010, though it wouldn’t surprise me if both Democrats and Republicans passed on grappling over a permanent change until 2011, after the mid-terms.