The estate tax is levied on all estates that exceed a certain value. In 2009, estates that were valued at $3.5 million were subject to the Federal estate tax. For people who die in 2011 or 2012, estates that are valued at $5 million are subject to the Federal estate tax.

The rule is a little bit more complicated for people who die during 2010, because the previous estate tax law lapsed at the end of 2009 and the new estate tax law was not created until the passage of the Tax Relief Act of 2010. That means that there is no estate tax levied on the estates of people who died during 2010.

While the complete lack of an estate tax sounds like a great boon, it carries with it some drawbacks. One of the most significant relates to aprinciple known as “basis.” Basis is the amount of money invested in an asset by the purchaser of the asset. If you buy 1000 shares of stock for $10 per share, and you pay your broker $20 for the transaction, then your basis is $9980 (1000 times $10 minus $20). Basis is important because it determines the amount of capital gains, gift, or estate tax that is levied on that property. For example, if you bought that stock in 2007 and then sold it in 2010 for $30 per share, you would net $29,980 (1000 times $30 minus $20). This exceeds the basis by $20,000, and so the applicable tax would be levied on $20,000.

For estate tax purposes, basis is important because it is used to determine the amount of the capital gains tax that you will pay when you ultimately sell the inherited property. To understand this, you have to be familiar with the estate tax rule called a “step-up in basis.” Estate tax laws provide that when you inherit property, your basis is deemed to be the value of the asset on the date of death of the person from whom you inherited the asset. Therefore, if your father purchased stock for $100,000 thirty years before his death and it is worth $3 million at the date of his death, you might think that you have to pay taxes on that $2.9 million in growth, but the step-up in basis provision means that when you inherit the property, your basis is deemed to be $3 million. Therefore, if you then sell it immediately for $3 million, you would face no capital gains tax.

But for people who died during 2010, when there was no estate tax, the rules are somewhat different.

The special rule for estates for people who died during 2010 is that the basis of the decedent’s property will be the lower of: (1) value on the date of death or (2) the decedent’s basis. It is usually relatively easy to know the value of an asset on the date of death. It is oftentimes far less easy to know the value of assets on the date that they were acquired, oftentimes decades ago. We are obligated to make a reasonable effort to establish the basis of all assets.

Of course, in almost all cases, the lower basis is the decedent’s basis. And sometimes that basis is very low. Consequently, when you inherit assets from someone who died in 2010, you will ordinarily inherit their very-low basis —- and therefore you will have to pay a huge capital gains tax when you sell that asset.

However, there are two additional rules that soften the blow considerably.

First, you are authorized to increase the basis by $1.3 million. In addition, the surviving spouse can increase the basis by an additional $3 million. Thus, ifyou inherit from your mother $3 million in stock that she purchased for $100,000, your basis would be $100,000 plus the adjustment that you can take of $1.3 million, for a total of $1.4 million. If you sell the stock immediately for $3 million, you will pay capital gains tax on $1.6 million (probably about $240,000) instead of on $2.9 million, saving at least $195,000 in taxes.

Second, under the 2010 Tax Relief Act, we also have the option of using the 2011 rules. The 2011 rules do impose an estate tax — but they also include a step up in basis. This means that your basis would be whatever the value is at the date of death, and if you sell the asset immediately, you will pay no capital gains tax. That saves you about $240,000 in capital gains taxes. Bear in mind that because the 2011 rules impose an estate tax, if you elect to follow the 2011 rules instead of the 2010 rules, you may have to pay an estate tax rather than the capital gains tax. The estate tax rate is much higher than the capital gains tax. Therefore, you must determine whether the estate is taxable before deciding which set of rules to apply.

Under the 2011 rules, the first $5 million of a decedent’s estate is exempt from taxes. Therefore, if the decedent’s estate is valued at less than $5 million, you should apply the 2011 rules so that even though you nominally must pay estate taxes, there would be a zero tax because it is all exempt — but under those 2011 rules you benefit from the step-up in basis.