Tax Guru – Ker$tetter Letter

There is a big difference in the carryover basis and potential capital gains taxes between having the transfer take place as a gift or as an inheritance. Besides the issues covered in the following email exchange, another common misconception I’d like to dispel is that a gift doesn’t have a zero cost basis just because the recipient didn’t personally pay anything for it. That idea has come up in a few recent conversations with clients.

I received the following question:

I am an attorney in Kentucky. I have a question about your website. You said that if a gift of non cash is made and the item is a highly appreciated one, the fair market value is used as the cost basis for the gift. In a case with a piece of real property here in Kentucky, the FMV of the property when the donor acquired it was $60,000. The FMV right now is $149,332. Would this be a situation where the FMV of the property becomes the recipients’ basis. If so, can you please point me to some statutory authority on this please. Thank you very much, keep up the good work on the website.

My response:

There seems to be a misunderstanding regarding the basis issue.

When a gift is made of an appreciated asset, the gift tax (Form 709) is based on the item’s current fair market value. However, the cost basis of that item on the books of the recipient is the same as it was for the item’s previous owner (giftor/donor) plus any gift tax that was paid on that item. As I explain to people, this means that responsibility for the future capital gains taxes on that item is also transferred to the recipient (giftee/donee). In your example, the $60,000 cost basis would transfer to the recipient.

This is quite different from how the basis is affected when items pass through inheritance. The fair market value at the time of death is used for estate and probate purposes, and it also becomes the basis on the heir’s books. The capital gain that had accumulated during the previous owner’s lifetime is literally wiped off the books. This stepped up basis for the heirs makes this one of the biggest tax saving opportunities available and is why gifting appreciated assets is not normally the best strategy.

This is also why the “swap ’til you drop” strategy of continuously using 1031 exchanges normally means that the accumulated gains are never subject to capital gains taxes. It has always bugged me to hear people say that they want to just sell their highly appreciated assets and pay the taxes so they won’t burden their kids with that responsibility. The exact opposite is true.

For decedents leaving an estate under the taxable threshold (currently $1,500,000), this means the gain is never taxed. For those whose estates are large enough to require an estate tax, there is a trade-off between wanting a high or low valuation on the estate tax return (Form 706) because of the normally higher estate tax rates.

I hope this clears things up.