Income tax basis can be an important factor in deciding whether to make gifts during your lifetime or transfer property at your death. This is because the income tax basis for the person receiving the property depends on whether the transfer is by gift or at death. This, in turn, affects the amount of taxable gain subject to income tax when the person sells the property.
What is income tax basis?
Income tax basis is the base figure used to determine whether a taxpayer has capital gain or loss on the sale of property for income tax purposes. When a taxpayer purchases property, the property’s basis is equal to the purchase price, subject to adjustments (resulting in “adjusted basis”). If you sell the property for more than your adjusted basis, you’ll have a gain. Sell the property for less than your adjusted basis, and you’ll have a loss.
For example, a taxpayer purchased stock for $25,000. Your basis in the stock is $25,000. If the taxpayer sells the stock for $27,000, it results in a gain of $2,000. If the taxpayer sells the stock for $20,000, it results in a loss of $5,000.
What is the income tax basis for property received by gift?
When a taxpayer receives a gift, the taxpayer generally takes the same basis in the property that the person who gave the property (the donor) had. (This is often referred to as a “carryover” or “transferred” basis.) The carryover basis is increased–but not above fair market value (FMV)–by any gift tax paid that is attributable to appreciation in value of the gift (appreciation is equal to the excess of FMV over the donor’s basis in the gift immediately before the gift). However, for purpose of determining loss on a subsequent sale, the carryover basis cannot exceed the FMV of the property at the time of the gift.
For example, if a generous aunt gives stock valued at $1,000 to her nephew. She purchased the stock for $500. Assume the gift incurs no gift tax. The nephew’s basis in the stock, for purpose of determining gain on the sale of the stock, is $500. If the nephew sold the stock for $1,000, he would have gain of $500 ($1,000 received minus $500 basis).
Now assume that the stock is worth only $200 at the time of the gift, and the nephew sells it for $200. The nephew’s basis in the stock, for purpose of determining gain on the sale of the stock, is still $500; but his basis for purpose of determining loss is $200. In this scenario, the nephew would not pay tax on the sale of the stock. He would not recognize a loss either. In this case, for better tax results, the aunt could have sold the stock, recognized the loss of $300. Then she could have transferred the sales proceeds to her nephew as a gift.
What is the income tax basis for inherited property?
When a taxpayer inherits property, the taxpayer generally receives an initial basis in property equal to the property’s FMV. The FMV is established on the date of death or, sometimes, on an alternate valuation date six months after death. This is often referred to as a “stepped-up basis,” since basis is typically stepped up to FMV. However, basis can also be “stepped down” to FMV.
For example, a taxpayer’s father leaves the taxpayer stock worth $100,000 at his death. The father purchased the stock for $10,000. The taxpayer’s basis in the stock is a stepped-up basis of $100,000. If the taxpayer later sells the stock for $100,000, the taxpayer would have no gain ($100,000 received minus $100,000 basis).
Transfers within one year of death. If a taxpayer transfers appreciated property to a person within one year of the person’s (donee’s) death, and then the taxpayer (or his/her spouse) receives the property back at that person’s (donee’s) death, the basis in the property is not stepped up or down to FMV. Instead, the basis in the property is equal to that person’s basis immediately before death (which would be probably close to the basis in the hands of the taxpayer originally had before transferring to the deceased person/donee).
This rule is designed to prevent a taxpayer from obtaining a stepped-up basis by transferring appreciated property to a dying person who then transfers it back to the taxpayer (or taxpayer’s spouse) at death. However, the rule does not apply if the dying person lives for more than one year after the taxpayer transfers the property to him or her. Also, the rule does not apply if the property passes from the decedent to someone other than the taxpayer or spouse (e.g., to one of the taxpayer’s children). In those cases, a stepped-up basis would be available.
Income in respect of a decedent (IRD). There is no step up (or step down) in basis for IRD. IRD is certain income that was not properly includable in taxable income for the year of the decedent’s death or a prior year. In other words, it is income that has not yet been taxed. Examples of IRD include installment payments and retirement accounts.
When a taxpayer inherits IRD, the taxpayer includes the IRD in income as the taxpayer receive payments, and take any related deductions. An income tax deduction may be available for any estate tax paid that’s attributable to the IRD.
How does generation-skipping transfer (GST) tax affect basis?
As discussed above, when someone makes a gift, the carry-over basis is increased (but not above FMV) by any gift tax paid that is attributable to appreciation in value of the gift. If the gift is also subject to GST tax, the carry-over basis is then increased (but not above FMV) by any GST tax paid that is attributable to appreciation in value of the gift.
Special rules can apply when property in a trust passes at the death of an individual.
Make gift now or transfer at death?
As the following example shows, income tax basis can be important when deciding whether to make gifts now or transfer property at your death.
In addition to income tax basis, the following might also need to be considered:
- Will making gifts reduce the taxpayer’s (donor’s) combined gift and estate taxes? For example, future appreciation on gifted property is removed from the donor’s gross estate for federal estate tax purposes. And gift tax paid on gifts made more than three years before the donor’s death is also removed from the donor’s gross estate.
- Does the recipient need a gift now or can it wait? How long would a recipient have to wait until the donor’s death?
- What are the marginal income tax rates of the donor and the recipient?
- Does a taxpayer have other property or cash that he or she could give?
- Can a taxpayer afford to make a gift now?
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