NAA/NMHC support estate tax reform that retains "stepped-up basis," increases the size of estates exempt from the tax and lowers the tax rate applied. NAA/NMHC oppose any estate tax repeal measures that also repeal stepped-up basis. Under such plans, heirs of commercial properties would avoid the estate tax only to find themselves owing substantial capital gains and recapture taxes. As a result, estates that contain real property are often worse off under full estate tax repeal than they would be if the estate tax were preserved.

Background

In 2001, Congress enacted legislation (P.L. 107-16) that made significant changes in the federal estate tax (sometimes referred to as the "death tax") over the 2001-2009 period by gradually increasing the size of estates exempt from the tax and gradually reducing the tax rate applied. In 2010, the estate tax is repealed, but only for one year due to quirky Senate procedural rules. In 2011, the law reverts to 2001 law, with low exemption levels and high tax rates.

This convoluted scenario is acceptable to neither estate tax proponents nor opponents. Permanently repealing the estate tax would cost the federal Treasury in excess of $520 billion, making such an action unlikely in light of the current federal deficit. However, a large and bipartisan group of lawmakers find the prospect of allowing the estate tax to revert in 2011 to higher tax rates and lower exemptions unacceptable. Thus, it is expected that some compromise legislation will be en-acted over the next two years. The details of what this compromise legislation will look like remains to be determined.

There are three key elements to any estate tax proposal:

1. the exemption level;
2. the estate tax rate; and
3. the basis rules. While all three elements are important for all types of estates, estates with significant amounts of depreciable real property are especially concerned with how various types of basis rules may affect them.

Exemption Levels: The estate tax exemption level is, in simplified terms, the amount that a donor may leave to an heir without incurring any federal estate tax liability. Under current law, the exemption is $2 million in 2008 and $3.5 million 2009. All estates are exempt in 2010, and then the exemption level falls to $1 million in 2011 when the temporary repeal expires.

Tax Rates: The estate tax rate is the tax rate that will apply to the amount of an estate that exceeds the exemp-tion level. Under current law, the maximum rate will be 45 percent in 2008 and 2009, zero in 2010, and 55 per-cent (plus an additional 5 percent surtax applicable to some estates) in 2011 and thereafter.

Basis Rules: The basis rules address what the tax basis will be of property inherited by an heir. There are gen-erally two different types of basis rules-stepped-up basis and rollover basis. With a stepped-up basis, the tax basis of inherited property is reset to reflect the fair market value of the property at the time of the inheritance. By contrast, under a rollover basis rule, the tax basis of the inherited properties is the same for heirs as it was for the donor (i.e., the heir "steps into the shoes" of the donor with regard to tax basis). This includes any decreases in tax basis to reflect depreciation allowances claimed by the donor in prior years. Stepped-up basis is the rule for all years except 2010, with a rollover basis generally in place for 2010 only.

The Importance of Stepped-Up Basis

Retaining a stepped-up basis rule is more important for estates that contain significant amounts of depreciated real prop-erty than it might be for estates that contain other types of property.

Under a rollover basis rule, an heir of commercial property "inherits" the donor's tax basis, which can be quite low if the property was purchased long ago and if it has been depreciated over a number of years. This creates two major disad-vantages compared to a stepped-up basis system. First, if the heir sells the property, they will likely face higher capital gains taxes (including recapture taxes). Second the heir will have a lower basis for purposes of determining any future tax depreciation deductions. NAA/NMHC Joint Legislative Program

Repealing stepped-up basis not only harms heirs of commercial property, it can also have the unintended consequence of exacerbating the nation's affordable housing shortage. Consider the not uncommon example of an heir who receives an apartment property that rents to low- and moderate-income households. The property has no basis and sizeable debt. If the heirs want to sell the property, they will face a depreciation recapture tax of 25 percent and a capital gains tax of 15 percent on any remaining gain, which is often more than the likely sales price of the property. Knowing that the property is likely worth less than the tax bill, the heirs will also be discouraged from investing the capital needed for proper upkeep. As a result, the property will remain "frozen" and may deteriorate to the point that it is lost to the affordable housing stock.

Preferred Outcome
Although it may seem somewhat counterintuitive, estates that contain a number of apartment buildings will often fair better under a system that retains an estate tax with a stepped-up basis (as the law will exist in 2009) than the one that elimi-nates the estate tax and replaces stepped-up basis with rollover basis (as the law will exist in 2010).

Current Status
Most of the activity in the estate tax area for early 2008 is expected to take place in the Senate Finance Committee, where Chairman Max Baucus (D-MT) committed last fall that the committee would examine an estate tax reform bill in early 2008. While no date has been discussed for examination of a possible bill, at least two hearings examining estate tax matters are expected to occur this spring.