A very common but often overlooked aspect of income taxation concerns the tax consequences of an individual's sale of an asset received either by inheritance or as a gift. When such property is sold, the question arises as to whether the seller has realized a taxable gain. The determination of gain depends on a key factor known as "basis," which is essentially the figure against which the selling price is measured to show whether there was a gain or loss.
Where an individual sells an asset that he purchased, his basis for determining gain or loss on his subsequent sale of the asset is normally his cost. Where the property was received by inheritance or as a gift, there is, of course, no cost to the recipient. Federal tax law provides a series of rules for establishing basis in such situations.
Calculating the Basis of Inherited Property
The general rule, which is usually favorable to taxpayers, is that the recipient's basis for inherited property is stepped up (or stepped down) from the decedent's cost to the asset's fair market value at the decedent's date of death. The advantage of a step-up in basis is demonstrated by the example of a decedent who bought shares of stock for $500 and held onto the investment until his death, at which time the stock had appreciated to a value of $1 million. The person who receives the stock upon the decedent's death will take a stepped-up basis of $1 million, the stock's fair market value at the decedent's death. Therefore, upon the recipient's subsequent sale of the stock, the appreciation in value between $500 and $1 million will not be recognized for income tax purposes, and the recipient of the stock will be taxed only on the gain represented by any appreciation of the stock beyond $1 million.
Calculating the Basis of Gifted Property
The rules as to basis in the case of a gift do not allow for a stepped-up calculation and they depend upon whether the basis is being calculated for purposes of gain or loss. For determining gain, the basis is the same as it would have been in the hands of the donor and is called a "carryover" basis. In the above example, if the individual who had acquired the shares of stock for $500 chooses to give them to the recipient as a gift and does not hold them until his death, the recipient takes the same $500 basis as the donor. Therefore, if the recipient sells the shares when they reach $1 million in value, the tax liability would be based on the gain of $999,500. The choice between transferring an appreciating asset by gift and holding it until death can be crucial for purposes of the recipient's income tax liability on a later sale.
Where an asset transferred by gift depreciates to a value below the donor's original cost, the recipient's basis is the fair market value of the asset at the time of the gift. Thus, in the stock example, if the shares that had cost the donor $500 were worth $250 at the time of the gift and had depreciated in value to $150 at the time of the recipient's subsequent sale, the recipient's basis for measuring his loss would be $250, and his loss would be $100. If, however, the stock had been worth $600 at the time of the gift but had declined to $300 by the time of the recipient's subsequent sale, the basis for loss would be the donor's basis of $500 (because that figure is lower than the $600 at the value date of the gift), and the recipient's loss would be $500 less $300.
Neither Gain Nor Loss
In the unusual situation where the recipient's selling price is higher than the asset's value on the date of the gift but lower than the donor's cost basis, the recipient will have neither a gain nor a loss. For instance, once again using the stock example and the donor's $500 cost basis, if the value of the shares at the time of the gift was $300 and the recipient sells the shares for $400, (1) there would be no gain because, for purposes of gain, the recipient would have a $500 carryover basis, which would be greater than the selling price, and (2) there would be no loss because the $400 selling price would be measured against a basis of $300, the lower of the asset's value at the time of the gift or the donor's cost basis.
The gift recipient's carryover basis can be increased where the donor has paid a federal gift tax on the transfer. The amount of the gift tax that is attributable to the appreciation in value of the asset as of the date of the gift can be added by the recipient to his carryover basis. For instance, if the donor's cost basis in an asset is $50,000, he transfers the asset as a gift when it is worth $100,000, and he pays a gift tax of $20,000, the appreciation in value ($50,000) accounts for one-half of the asset's value at the time of the gift. Therefore, the recipient is entitled to add one-half of the gift tax liability ($10,000) to his carryover basis, resulting in a carryover basis of $60,000.
Even with such breaks, from the standpoint of the recipient's income tax liability on later sale the disadvantages of making lifetime gifts are clear. Of course, there are situations where the immediate transfer of property is so strongly desired and the consideration of the recipient's later income tax liability is not a priority. Tax savings should not be allowed to overwhelm the basic reasons for the transfer itself.
This article introduces the tax consequences of selling an asset that is inherited or received as a gift. Estate planning and tax laws are complex. You should always consult with a qualified professional to assist you in such matters.