Taxation of Gifted Securities

Understanding how to value a gift is one thing; knowing the cost basis the recipient inherits is where the exam gets tricky. When you receive securities as a gift, your cost basis depends on whether the gift was appreciated or depreciated at the time of transfer.

What Is the Dual Basis Rule?

The cost basis for gifted securities follows a set of rules that create three possible outcomes depending on the sale price:

• The dual basis rule applies only when the FMV at the time of gift is lower than the donor's original cost basis (a gift of depreciated property)
• If FMV at gift is equal to or greater than the donor's basis, the donee simply uses carryover basis in all cases

How Are Appreciated Gifts Taxed (the Simple Case)?

When the gift has gone up in value, the rules are straightforward:

Example:

• Donor bought stock at $30/share
• FMV when gifted is $80/share
• Donee's cost basis: $30 (carryover basis from donor)
• Donee's holding period: Donor's original acquisition date tacks on

If the donee sells at $100:

• Capital gain = $100 - $30 = $70
• Long-term if the combined holding period (donor + donee) exceeds 1 year

Exam Tip: Gotchas

• For appreciated gifts, always use carryover basis (donor's basis). The holding period also carries over from the donor.

How Are Depreciated Gifts Taxed (the Tricky Case)?

When the gift has lost value, the dual basis rule creates a "no man's land":

Example:

• Donor bought stock at $80/share
• FMV when gifted is $50/share

Three possible outcomes based on sale price:

The zone between $50 and $80 is the "no man's land": any sale in this range results in zero taxable gain or loss.

Think of it this way: The donor's basis ($80) is the ceiling and the FMV at gift ($50) is the floor. Sell above the ceiling, you have a gain measured from the ceiling. Sell below the floor, you have a loss measured from the floor. Sell between the two, and the IRS says there is nothing to report.

Exam Tip: Gotchas

• The "no man's land" between the donor's basis and the FMV at the time of gift is one of the most frequently tested concepts. If the sale price falls between these two values, the answer is always "no gain or loss recognized."
• For depreciated gifts, the basis depends on the sale price. There is no single answer. The holding period tacks on for gains (carryover basis) but starts fresh, the day after the gift date, for losses (FMV basis).
• The answer is NOT "use the lower basis." The correct analysis requires comparing the sale price to both reference points.

What Is the Gift Tax Paid Adjustment?

If the donor pays gift tax on the transfer, a portion of that tax may increase the donee's cost basis:

• The increase is limited to the gift tax attributable to the net appreciation in the gift (the excess of FMV over donor's basis)
• This adjustment only applies when FMV exceeds the donor's basis (appreciated gifts)
• No adjustment for depreciated gifts

Exam Tip: Gotchas

• The gift tax adjustment only applies to appreciated gifts. If the FMV at the time of the gift was below the donor's basis, no gift tax adjustment is available.

What Should You Check on Exam Day?

• Gain scenario: carryover basis (donor's basis), donor's holding period tacks on.
• Loss scenario: FMV-at-gift basis, a brand-new holding period that starts the day after the gift date. This scenario only exists when FMV at the gift date is below the donor's basis.
• Sale price between the donor's basis and the FMV at gift: no gain or loss, regardless of how long the security is held.
• Gift tax paid by the donor can raise the donee's basis, but only for the appreciated-gift scenario, never the depreciated one.