In the last post, we saw how tax plays a important role in gifting to charity or a family member. We saw the tax consequence like deductions and exclusion from donor’s perspective. After that post, I got a request to explain about cost basis in relation to gifting. At times we do recieve gifts or inherit properties from our family members so we need to look at tax implications from donee’s perspective to declare gains or losses from those gifts. In order to report gain or loss from the gifts or inheritance, cost basis is an important factor needs to be considered.
What is Cost Basis?
Cost basis is the original cost paid for the property including any commission or fees involved to acquire the proeprty whether its tangible(home, equipments) or intangible (stocks, bonds). If a property is purchased, the cost basis is the cost associated with the property including all the expenses related to the purchase. In this post we will see more about the cost basis involved with gifting or inheritance.
Why cost basis important?
When you inherit/get gifts of property, starting cost basis is set according to the acquired method. When those properties are sold, the selling price is usually different from the original purchase price. Either a capital gain or a capital loss is realized during this transaction which needs to be reported to the IRS by the taxpayer. In order to calculate the amount of capital gains and losses the cost basis of the stock must be determined.
It can be a short term or long term capital gain depends on the holding period of the property. For gifted property, holding period various depending up on the length property owned by donor and donee. If you are using stepped up basis for inheritance property, it is always long term holding period.
Cost basis – Gifted Property
If the property is received as a gift then the basis is various depending on the FMV of the gift at the date of gift or original cost of the property bought by the donor.
The donee’s starting cost basis is the lesser of either:
cost basis of the person who gifted the property which is called carryover basis, or the market value of the stock on the date the gift which is called stepped up basis. It depends on the property value at the time of gift and property sale value by the donee.
If the FMV of the property gifted is more than original cost, donee should use the cost basis of the donor. That means donee carry’s over the donor’s cost basis. On the other hand if the FMV of the property is less than original cost, then dual basis rule comes in to play depending on the sale price. That is, if the donee sells above donors cost basis, then donee takes donor basis and report gain. If the donee sells below of the donors cost basis, then donee takes the FMV as the cost basis. If the donee sales between FMV and donors cost basis, no gain or loss need to be reported. I know its bit confusing but look at the example below and it will be clear.
An example of basis in which a gift results in a gain would be as follows:
Anna gives Sara a painting. Ronald paid $10,000 for the painting, and the fair market value (FMV) of the painting is $20,000 at the date of the gift. If Sara sells the painting for $20,000 she will use Anna’s cost basis of $10,000 is used to report the capital gain. Thats carryover basis.
However, the example above does not apply if Anna had gifted his painting to Sara when its FMV was $8,000, which is less than his original basis of $10,000. The capital gain or loss reported by Sara depends on whether she subsequently sells the stock for a gain or a loss.
Let’s look another example in which the same gift could result in a loss:
If Sara sold the painting for $15,000 then Sara would report a capital gain of $5,000 using Anna’s original basis of $10,000 to calculate her gain. However, if Sara sold the painting for $5,000 she would report a loss of $3,000 using the stock’s FMV basis of $8,000 to determine her loss. Note that if Sara sold the stock for $9,000 she would not report a gain or a loss in this situation.
Cost Basis – Inherited Property
If you inherit a property, the cost basis will depend on when you inherited it and who you inherited it from. In general, if you inherit it before 1/1/2010, the cost basis is “stepped up” from the original cost paid by the deceased owner to the fair market value on the date it was bequeathed to you. This is called a stepped-up basis. Stepped basis is when the donee(who recieves the stocks) gets the FMV (fare market value) as their starting basis instead of donor’s original basis.
You can use the free calculator available at costbasis.com
You might have recently received an email or mail from your broker about Cost basis reporting. It was part of the “Bailout Bill” signed in 2008. This bill is $11 billion cost basis reporting. Starting from 2011, every broker or agent should track the cost basis of the investments and report at the end of year to help the investors to easily track their cost basis and fill the taxes properly. For more details, you can check out the article at WSJ. It will surely save you time and money for the government.