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REG Practice Questions Explained: Calculate the Basis of Gifted or Inherited Assets

Calculate the basis of gifted or inherited assets

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In this video, we walk through 5 REG practice questions demonstrating how to calculate the basis of gifted or inherited assets. These questions are from REG content area 3 on the AICPA CPA exam blueprints: Taxation of Property Transactions.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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How to Calculate the Basis of Gifted or Inherited Assets

When you receive a gift, the general rule is that your basis in the gifted asset is the same as the donor’s basis. This is often referred to as the “carryover basis.” The carryover basis rule ensures that any gain the asset has accrued while in the donor’s possession is subject to tax when the recipient eventually sells the asset. However, determining the basis for calculating a loss on the sale of a gifted asset introduces additional complexity.

Tax Basis of Gifted Assets

Determining the Basis for Gain

  • For Gain Calculations: If you sell the gifted asset for more than its value at the time of the gift, you use the donor’s adjusted basis plus or minus any required adjustments during the period you held the asset to calculate your gain. This might include improvements you made to the property, which can increase your basis.

Determining the Basis for Loss

  • For Loss Calculations: If you sell the gifted asset for less than its value at the time of the gift, a different basis is used for calculating a loss. In this scenario, your basis for determining the loss is the fair market value (FMV) of the asset at the time of the gift, not the donor’s original basis. This rule is designed to prevent taxpayers from claiming a tax deduction for a market loss that occurred before they owned the asset.

Dual Basis

The concept of “dual basis” comes into play because of these rules. A gifted asset can effectively have two different bases: one for calculating gains (the donor’s adjusted basis) and another for calculating losses (the FMV at the time of the gift). Which basis applies depends on the selling price of the asset relative to both the donor’s adjusted basis and the FMV at the time of the gift.

Examples

  • If the donor’s adjusted basis was $5,000, and the FMV at the time of the gift was $4,000, and you later sell the asset for $6,000, you have a gain. You calculate the gain using the donor’s basis ($5,000), resulting in a gain of $1,000.
  • If, instead, you sell the asset for $3,000, you have a loss. For the loss calculation, you use the FMV at the time of the gift ($4,000) as your basis, resulting in a loss of $1,000.

Special Considerations

  • Gift Tax Adjustment: If the donor paid gift tax on the transfer, you might be able to increase your basis in the asset. The increase is a portion of the gift tax paid that is attributable to the net appreciation in value of the gift. This calculation can be complex and typically requires professional assistance.
  • Selling Price Between Donor’s Basis and FMV: If the selling price is between the donor’s adjusted basis and the FMV at the time of the gift, you neither recognize a gain nor a loss.

Tax Basis of Inherited Assets

Inherited assets typically enjoy a “stepped-up” basis, which is quite different from the carryover basis of gifted assets. This rule can significantly reduce capital gains tax when the asset is sold.

  1. Stepped-Up Basis: The basis of an inherited asset is generally its fair market value (FMV) at the date of the decedent’s death. This adjustment often reduces potential capital gains taxes if the asset has appreciated over time since the heir’s basis is “stepped up” to the market value as of the inheritance date.
  2. Alternative Valuation Date: Executors of an estate may choose to use an alternative valuation date six months after the date of death, under certain conditions. This choice can affect the basis of inherited assets if the estate’s value and consequently, estate taxes, are reduced.
  3. Special Rules: Certain assets, like IRAs and other retirement accounts, have their own set of rules for determining the basis and are not subject to the stepped-up basis rules.

Example

Imagine you inherited a house from a relative who passed away. For simplicity, we’ll ignore potential complications like estate taxes or debts against the estate.

  • FMV at the Time of Death: The FMV of the house at your relative’s date of death was $300,000.
  • Decedent’s Purchase Price: Your relative originally purchased the house for $100,000 many years ago.

Step-by-Step Calculation

  1. Determine the Date of Death FMV: The first step is to establish the fair market value of the house at the time of your relative’s death. This is often done through a professional appraisal. In this example, that value is $300,000.
  2. Apply the Stepped-Up Basis Rule: Instead of the basis being what your relative paid for the house ($100,000), the tax basis for you, the inheritor, is “stepped up” to the FMV on the date of death, which is $300,000.
  3. Calculate Gain or Loss on Future Sale: If you sell the house, your capital gain or loss will be based on this stepped-up basis.
    • For example, if you later sell the house for $320,000, your capital gain would be calculated as follows: $320,000 (selling price) – $300,000 (stepped-up basis) = $20,000 capital gain.
    • Conversely, if the real estate market declines and you sell the house for $290,000, your capital loss would be: $300,000 (stepped-up basis) – $290,000 (selling price) = $10,000 capital loss.

Key Differences

  • Gifted Assets: Basis is generally the donor’s basis at the time of the gift (carryover basis). Adjustments are possible if there’s gift tax involved or if calculating loss.
  • Inherited Assets: Basis is generally the fair market value at the date of the decedent’s death (stepped-up basis), potentially reducing capital gains tax due.

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