Basis of Assets Received by Gift or Inheritance

12.2 Basis of Assets Received by Gift or Inheritance

The determination of a taxpayer’s “basis” in property is one of the most fundamental concepts in United States taxation. Understanding how to calculate and adjust basis is essential for computing gain or loss on the disposition of assets, as well as for leveraging potential deductions or credits. This section focuses on the unique rules that apply to property received by gift or inheritance—a topic that has significant implications for estate planning, individual tax returns, and entity-level transactions.

Traditional tax rules generally provide two primary baseline approaches for property transferred outside of a typical sale: • Carryover basis for gifts.
• Stepped-up (or stepped-down) basis for inherited property.

Below is a detailed exploration of each approach, including where the rules come from, how they are applied, and how they might affect a taxpayer’s ultimate gain or loss when the property is sold or exchanged.

Understanding the Distinction: Gift vs. Inheritance

Before calculating basis, it is critical to ascertain whether the asset was received as a gift during the donor’s lifetime or through inheritance from a decedent’s estate. Each route has unique tax consequences:

• A gift implies a transfer made without expecting anything in return, usually during the donor’s life.
• An inheritance refers to assets received from a decedent’s estate, often passing under a will or by operation of law.

For gifts, the general rule is that the donor’s basis for the property “carries over” to the recipient. For inherited property, special rules often allow a “stepped-up” or “stepped-down” basis adjustment to fair market value (FMV) as of the date of death (or an alternate valuation date, if elected by the estate).

Carryover Basis for Gifted Property

When a donor transfers property by gift, the donee (gift recipient) typically takes the donor’s adjusted basis in the property. This means if the donor’s basis in real estate was USD 50,000 at the time of the gift, and the property is then worth USD 120,000, the gift recipient generally inherits (or “carries over”) the donor’s USD 50,000 basis. Therefore, the recipient would calculate any future capital gain or loss using that same USD 50,000 basis, subject to certain adjustments or exceptions explained below.

The Double Basis Rule

A special twist arises if the FMV of the gifted property at the time of the gift is less than the donor’s basis. In such cases, there is a split or “double basis.” Specifically: • Basis for calculating gain is the donor’s carryover basis.
• Basis for calculating loss is the FMV on the date of the gift.

If the ultimate sale price is somewhere between these two bases, the donee recognizes no gain or loss. This rule prevents taxpayers from converting a loss that existed in the donor’s hands into a legitimate deductible loss in the donee’s hands. The intended policy behind this rule is to avoid “tax loss shifting” where a donation of property might otherwise yield a higher deductible loss for the recipient.

Gift Tax Implications

Although gifts are often tax-free to the donee at the time of receipt, the donor might pay gift tax on property transfers exceeding the annual or lifetime exclusion thresholds. If gift tax is paid, the donee’s basis can be increased, but only by the portion of gift tax attributable to the net appreciation in the property’s value (essentially the amount by which FMV exceeds the donor’s basis at the time of the gift).

Mathematically, the basis increase due to gift tax is often expressed as:

Bnew = Bdonor + ( ( FMV at gift - Bdonor ) / ( FMV at gift ) × Gift Tax Paid )

Here,
• Bnew = adjusted basis for the donee,
• Bdonor = donor’s basis,
• FMV at gift = fair market value of the property on date of gift.

Keep in mind, gift tax rarely overrides the general carryover basis rule. Rather, it simply adds a partial “step-up” to reflect the tax cost already incurred by the donor.

Holding Period for Gifted Property

The holding period for property received by gift (for capital gain purposes) usually includes the donor’s holding period. This means that if the donor held the property for three years before gifting it, the donee’s holding period starts on the date the donor’s holding period commenced. In practice, this effectively allows the recipient to treat the property as if they owned it for the entire time the donor did, helpful when qualifying for long-term capital gains treatment.

However, the holding period for losses might differ if the FMV at the date of gift is used as the donee’s basis for loss. In such a scenario, the holding period technically starts on the date of the gift.

Stepped-Up (or Stepped-Down) Basis for Inherited Property

Unlike a gift’s carryover basis, inherited property typically takes a “step-up” (or step-down) in basis to its FMV on (1) the date of the decedent’s death, or (2) the alternate valuation date if the estate has validly elected such date. This rule significantly reduces or even eliminates built-in gains that accrued during the decedent’s lifetime.

Fair Market Value at Date of Death

In most cases, the basis for inherited property defaults to the FMV on the date of death. If the decedent originally purchased a piece of land for USD 50,000, but it was worth USD 150,000 at the time of death, the heir’s basis is USD 150,000, thus eliminating any gain accrued during the decedent’s life. This rule can represent a substantial tax benefit to heirs, often referred to as the “step-up in basis.”

Alternate Valuation Date

An executor of an estate can choose an alternate valuation date—generally six months after the date of death—to determine the FMV of certain assets if doing so both: • Lowers the overall gross estate value, and
• Reduces the estate tax due.

When an alternate valuation date is elected, the basis for inherited property becomes the FMV on that alternate valuation date rather than on the date of death (subject to detailed rules and limitations under Internal Revenue Code requirements).

Automatically Long-Term Holding Period

A noteworthy distinction for inherited property is that its holding period is always considered long-term. Regardless of how soon the heir sells the asset after inheriting it, any gain or loss will be treated as long-term for tax purposes. This rule significantly simplifies the classification of capital gains and losses on inherited property, as the typical multi-year holding requirement does not apply.

Special Considerations for Inherited Property

Several special rules or exceptions may come into play:

• Community Property States: In a community property state, the surviving spouse’s one-half share of community property can also get a step-up. Under certain conditions, both halves of the property receive a full step-up.
• Valuation Discounts: Estates can often reduce the valuation of certain inherited assets using fractional interest, minority, or lack-of-marketability discounts, impacting how the FMV is calculated.
• Sections 2032A and 2057 Special Use Valuation: Real estate used in certain qualified family business or farming activities can be valued at something other than its highest and best use to reduce the estate’s tax burden. This can influence the basis for the heirs.

Diagram: Gift vs. Inheritance Basis at a Glance

Below is a simple Mermaid.js flowchart illustrating the decision points when determining whether to apply carryover basis (gift) or stepped-up basis (inheritance). This can serve as a quick reference for how each rule is applied.

    flowchart LR
	    A["Property Received?"] --> B{"Was it a gift<br/>during donor's lifetime?"}
	    B -- "Yes" --> C["Carryover basis<br/>(possibly adjusted by 'double basis' rule or gift tax)"]
	    B -- "No" --> D{"Was it inherited<br/>from a decedent?"}
	    D -- "Yes" --> E["Stepped-up or stepped-down basis<br/>to FMV at date of death<br/>(or alternate valuation date)"]
	    D -- "No" --> F["Other basis rules apply<br/>(e.g., purchase or exchange)"]

In practice, the key pivot point is whether the property was gifted while the donor was alive or inherited. Each branch leads to distinct calculation rules.

Examples and Case Studies

Example 1: Gift with Appreciated Value

• Donor’s basis (in stock) = USD 20,000
• FMV on date of gift = USD 60,000

The donee receives a carryover basis of USD 20,000. If the donee sells the stock a year later for USD 65,000, the donee’s gain is USD 45,000 (sales price minus the USD 20,000 original carryover basis). The holding period includes the donor’s, so the sale is treated as a long-term capital gain.

Example 2: Gift with a Built-In Loss (Double Basis Rule)

• Donor’s basis (in a parcel of land) = USD 100,000
• FMV on date of gift = USD 80,000

Since FMV < donor’s basis, the donee’s gain basis is USD 100,000, but loss basis is USD 80,000. Consider two scenarios for the donee’s subsequent sale:

1. Sells at USD 90,000: Because the sales price (USD 90,000) is between the loss basis (USD 80,000) and the gain basis (USD 100,000), there is no recognizable gain or loss.
2. Sells at USD 110,000: Now the sales price (USD 110,000) is above the gain basis. The donee’s recognized gain is USD 10,000 (USD 110,000 – USD 100,000).

Example 3: Inherited Property with Stepped-Up Basis

• Decedent’s basis in real estate = USD 25,000
• FMV at date of death = USD 200,000

The heir’s basis is stepped up to USD 200,000. If the heir sells the real estate a month later at USD 210,000, the heir recognizes a USD 10,000 long-term capital gain (USD 210,000 – USD 200,000), even though the decedent originally bought it for much less.

Example 4: Alternate Valuation Date

Suppose the date-of-death value of estate assets is USD 1,000,000, but six months later, the value drops to USD 950,000. The executor may choose the alternate valuation date if it reduces estate taxes. Consequently, the heir’s basis in each asset is set to the FMV at the alternate date. So if a particular stock was worth USD 200,000 at date of death and USD 185,000 six months later, the heir’s stepped-up basis would become USD 185,000.

Common Pitfalls and Best Practices

• Neglecting the Double Basis Rule: Taxpayers often overlook the possibility that an asset might have declined in value in the donor’s hands. This oversight can lead to errors in loss reporting.
• Failing to Substantiate FMV: Whether for gift or inherited property, it is crucial to document the property’s FMV at the appropriate date. A formal appraisal is often recommended for high-value or unique assets.
• Misjudging the Holding Period for Gifts: Practitioners sometimes mistake the holding period for the donee if the gift’s FMV was less than the donor’s basis.
• Overlooking Gift Tax or Estate Tax Adjustments: If the donor paid gift tax or if the estate elected the alternate valuation date, these can each significantly affect basis calculations. Always consider these elections when establishing basis for subsequent dispositions.

Strategies to Overcome Challenges

• Obtain Professional Appraisals: Particularly when the fair market value is not readily ascertainable, a professional appraisal is invaluable for accurate basis determination.
• Keep Complete Records: Encourage donors and executors to maintain documents such as purchase records, depreciation schedules, capital improvements, gift tax returns (Form 709), estate tax returns (Form 706), and any letters from appraisers.
• Plan Gifting vs. Inheritance Based on Tax Efficiency: Sometimes, a taxpayer may benefit from passing assets as an inheritance (to secure a step-up in basis) rather than as a lifetime gift. This is especially true for assets that have appreciably grown in value.
• Seek Professional Guidance: Every situation is unique. Taxpayers and practitioners should consult with trusts and estates attorneys, tax advisors, or CPAs to navigate intricate basis rules, especially in large or complex estates.

Table: Quick Comparison of Gift vs. Inherited Basis

References for Further Exploration

• IRS Publication 551 – “Basis of Assets”
• IRS Publication 559 – “Survivors, Executors, and Administrators”
• IRC Sections 1014 (Basis of property acquired from a decedent) and 1015 (Basis of property acquired by gifts and transfers in trust)
• IRC Section 2032 (Alternate valuation date)
• Chapter 31: Complex Problem Dissections (for advanced scenarios and practice questions related to property basis)

These resources offer deeper guidance and are recommended for those seeking to expand their knowledge or research complicated aspects of basis transfers.

Quiz: Basis for Gifted and Inherited Assets

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