The Estate Tax Repeal Legislation, approved by the House of Representatives, suffers from major flaws. This is because it will substitute a potentially greater "Death Tax" tax for the one repealed. Hardest hit would likely be family owned real estate businesses, which could be financially devastated by this new "Death Tax." For many, the new "Death Tax" could be greater than the assets of the estate, leaving it literally insolvent or bankrupt. The types of owners effected could run the gamut from farmers and ranchers, on the one hand, to owners of rental residential and commercial properties, on the other. These are precisely the people the repeal of the Estate tax was supposed to benefit.

The new "Death Tax" would be caused by the repeal of the unlimited stepped up basis. One of the reasons for the unlimited stepped up basis under the current Estate Tax law is to protect heirs from being tax on the same wealth twice. It was thought that if an Estate Tax were paid, it would be unfair to then impose a capital gains tax on the same property.

The unlimited stepped up basis eliminates the income taxes that would have been paid by the decedent if the property were sold. At first blush, it seems that if the Estate Tax is repealed, there is no justification for this "free ride."

However, upon closer analysis, that is not always the case. This is because if the unlimited stepped up basis is repealed, the income tax burden shifted to the estate and heirs could be greater than the value of the inherited property. This income tax could not only be greater than the estate tax would have been, but it could also leave the estate or heirs literally bankrupt.

At the last minute, the Death Tax Repeal legislation passed by the House was amended to include a provision that appears intended to prevent this income tax liability from being triggered at the time of death. This change merely delays the day of reckoning; it is poorly drafted; and may not cover all situations. It does not address the real problem, which is that this new, and potentially greater, income tax burden will fall on the heirs sooner or later (i.e., when the property is sold or even sooner).

Over a year ago, when the momentum for the Estate Tax repeal was first building, I testified at the Congressional hearings conducted by the House of Representatives Committee on Small Business. My testimony followed that of a farmer, a cattle rancher, and other family and small business owners. The legislation was crafted to protect these people and to preserve their businesses - not to raise income taxes on them and their estates.

This problem results from the fact that the adjusted income tax "cost" basis in real estate may be significantly less than the mortgage. It is not uncommon for real estate to have a very low income tax basis because it has been held for many years, refinanced, or depreciated under regular income tax rules. For example, a property could be worth $5,000,000. However, it could be subject to a mortgage of $4,000,000 and have an income tax basis of $10,000. Thus, the owner's equity interest is only worth $1,000,000. This is the amount subject to estate tax under current law. Under current law, the maximum estate tax that could be imposed upon that interest would be $550,000.

After the Estate Tax repeal, if the property is sold or gifted by the heirs, the real estate could be deemed to be sold to the heirs for at least $5,000,000. The income tax if the Estate Tax is repealed on that deemed sale could be $1,000,000 or more. Under current law, before the repeal, that income tax would be $0. The income tax is at least $450,000 greater than the estate tax that would be imposed under current law. The heirs could be left literally bankrupt. The net effect is an imposition of a new "Death Tax" at a rate of at least 100%.

The provision added to the House version of the Death Tax Elimination Bill was designed to prevent this new income tax from being imposed at the moment of death. However, it was hastily drafted and does not clearly prevent the tax at death for property owned by partnerships and limited liability companies. As already stated, this provision merely delays the day of reckoning. It does not eliminate this new income tax.

Clearly this result is not in the spirit of eliminating the "Death Tax." The Repeal of the Estate Tax as passed by the U.S. House of Representatives is ill conceived and, if passed in its current form, will no doubt force many family owned real estate businesses in much worse financial condition than if an Estate Tax were paid under current law.

If the Estate Tax Repeal is to become law, it must be modified to prevent this new "Death Tax." My recommendation is to leave intact the basis step up to the extent necessary to prevent estates and heirs from inheriting tax liabilities caused by mortgages that exceed income tax basis of inherited real estate. This could easily be drafted into the legislation with appropriate anti-abuse provisions. If this change is made, the repeal of the unlimited stepped up basis would work the way it is supposed to. Namely, it would apply only to the "real" value of inherited property. Potentially ruinous "phantom" income tax would not be passed to heirs. Consequently, the Estate Tax Repeal would provide a real benefit to family owned real estate business. It would also be much more fair since all real estate heirs and owners would be treated much more equitably.

Lastly, the legislation passed by the House doesn't even do what it purports to do --- namely, repeal the Estate Tax. For people who forestall proper tax planning, they will be in for a rude awakening. The House Bill reduces the Estate tax minimally during the next 10 years. After 2011, when the actual repeal is supposed to occur, there is a good chance it will never happen. Even Senate Finance Committee Chair Charles E. Grassley, a Republican Senator from Iowa, acknowledged the other day that the repeal legislation passed by the House will expire before it goes into effect under the budget rules.