Most apartment owners cheered in 2001 when a new law was passed to gradually phase out the estate tax, but a closer examination shows that the law could actually hurt many property owners.

First, the new law does not permanently repeal the estate tax, as many assume. Between 2002 to 2009, it gradually reduces the tax rate and increases the size of estates excluded from taxation. Then for nine months in 2010, it temporarily repeals the estate tax completely. But because the Senate vote fell two votes short of the 60 required to make its estate law change permanent in 2010, the estate tax law reverts back to the way it was written in 2001.

To the detriment of property owners, the estate tax “repeal” also repeals what is known as “stepped-up basis.” Under stepped-up basis, when heirs sell their inherited property, they pay capital gains based on the property's fair market value at the time it was inherited. Without stepped-up basis, capital gains taxes are based on the higher accounting basis (the original purchase price less any depreciation taken by the donor).

A very simplified example shows why the repeal of stepped-up basis matters. Assume you inherit commercial real estate with a fair market value of $100 million that is encumbered by $70 million in debt. The real estate was originally purchased for $5 million and has depreciated to zero. Let's look at how your estate will be taxed under three different scenarios.

Option No. 1 — Permanent Repeal: $23.75 million tax bill

  • There is no estate tax when you inherit the estate.

  • When you sell the property, you will have to pay capital gains tax on your gain.

  • Since there is no stepped-up basis, your gain is the fair market value ($100 million) minus the original purchase price ($5 million).

  • So your tax is $95 million x 25% capital gains tax rate (the present depreciation recapture tax rate) for a total tax of $23.75 million.

  • Additionally, since stepped-up basis is repealed and the property has already been fully depreciated, you cannot take a depreciation deduction while you own it.



Option No. 2 — Revert to 2001 Law: $16.5 million tax bill

  • A 55% estate tax is levied on all estates over $1 million (practically speaking, $2 million for a married couple).

  • The tax due at the time of inheritance is based on the value of the property minus any debt.

  • In our example, $30 million is taxed ($100 million FMV - $70 million debt) at 55% for a total tax due of $16.5 million.

  • Since stepped-up basis still exists, assets are stepped-up to fair market value at the time of the donor's death. That means that when you sell, the capital gains tax will be based on the fair market value of $100 million, not the original $5 million purchase price.

  • In addition, you can take a depreciation deduction based on the $100 million fair market value while you hold it.



Option No. 3 — Extend 2009 Law: $13.5 million tax bill

  • A 45% estate tax rate is applied to assets beyond the $3.5 million exclusion (practically speaking, this is $7 million for a married couple).

  • The tax due, at the time of inheritance, is based on the value of the property minus any debt.

  • In our example, $30 million is taxed ($100 million FMV - $70 million debt) at 45% for a total tax due of $13.5 million.

  • As with Option No. 2, the assets are stepped-up to the $100 million fair market value for determining later capital gains taxes, and heirs can take a depreciation deduction based on the $100 million fair market value while you hold it.



Most real estate investors would automatically choose Option No. 1. But for estates with a sizeable percentage of depreciable commercial property, Option No. 3 is the better choice.

Because the 2001 tax law change is only temporary, Congress knows it needs to take up estate taxes again. It essentially has three options: (1) secure the 60 votes needed for permanent repeal; (2) allow the temporary repeal to expire in 2010 and revert to 2001 law; (3) extend the law as it will exist in 2009.

The $100 billion annual price tag of a permanent repeal will make it difficult to pass Option No. 1. That makes reversion to the 2001 law (Option No. 2) or extension of the 2009 law (Option No. 3), which are significantly less expensive, more likely options. Contrary to the conventional wisdom, commercial property owners should urge for Option No. 3 — extension of the 2009 law.

Jim Arbury is the vice president of tax for the Washington, D.C.-based National Multi Housing Council and its joint legislative partner, the National Apartment Association.