Cost Basis: Inherited or Gifted Securities
How you received a security (by inheritance or as a gift) completely changes the cost basis rules. These are among the most frequently tested topics on the Series 7.
Inherited Securities: Stepped-Up Basis
When you inherit securities, you get a major tax benefit:
- Cost basis is stepped up (or stepped down) to the fair market value (FMV) on the date of the decedent's death
- Alternatively, the executor may elect the alternate valuation date (6 months after death) if it reduces the estate's total value
- All inherited securities are treated as long-term regardless of how long the decedent or beneficiary held them
- This eliminates all unrealized gains that accrued during the decedent's lifetime
Example:
- Grandparent bought stock at $10/share decades ago
- Grandparent passes away when stock is worth $100/share
- Beneficiary inherits with a stepped-up basis of $100/share
- If beneficiary immediately sells at $102: gain = only $2/share (not $92)
- The gain is long-term regardless of how quickly the beneficiary sells
Key points:
- The step-up also works in reverse: if the stock declined, the basis is "stepped down" to the lower FMV
- The alternate valuation date (6 months after death) can only be elected if it reduces the estate's value
- The alternate valuation date requires filing an estate tax return (Form 706)
Exam Tip: Gotchas
- Inherited securities are always long-term, even if the beneficiary sells the next day. The holding period does not restart.
- The alternate valuation date is not always available. It requires filing Form 706 and must reduce the estate's total value.
Gifted Securities: The Dual Basis Rule
Gifted securities use a carryover basis system, but with an important twist when the gift involves depreciated property (FMV at gift < donor's basis):
| Scenario | Cost Basis Used | Holding Period |
|---|---|---|
| Sold at a gain (sale price > donor's basis) | Donor's original cost basis (carryover) | Donor's holding period tacks on |
| Sold at a loss (sale price < FMV at time of gift) | FMV on the date of the gift | New holding period starts at gift date |
| Sale price between donor's basis and FMV at gift | No gain or loss recognized | N/A |
The third scenario is sometimes called the "no man's land" zone: a sale price that falls between the donor's basis and the (lower) FMV at the time of the gift produces no taxable event.
Think of it this way: When someone gives you stock that has lost value, the IRS gives you two separate price tags. One tag (the donor's original cost) is for measuring gains. The other tag (the FMV when you received the gift) is for measuring losses. If your sale price lands between those two tags, neither applies, so there is no taxable event.
Worked Example: Gifted Securities
- Donor bought stock at $80/share
- FMV when gifted to recipient: $50/share (depreciated property)
| If Recipient Sells At | Basis Used | Result |
|---|---|---|
| $90 | Donor's basis ($80) | $10 gain (long-term if donor's + recipient's holding period > 1 year) |
| $40 | FMV at gift ($50) | $10 loss (holding period starts at gift date) |
| $60 | Neither applies | No gain or loss (between $50 and $80) |
Exam Tip: Gotchas
- For losses on gifted securities, use FMV at the gift date as the basis, not the donor's original cost. This is the most common mistake on gift basis questions.
- The "no man's land" zone produces zero taxable gain or loss. If the sale price falls between the donor's basis and the FMV at the time of the gift, no tax event occurs.
When the Dual Basis Rule Does NOT Apply
The dual basis rule only matters when the FMV at the time of the gift is lower than the donor's cost basis (a gift of depreciated property).
If the FMV at the time of the gift is equal to or higher than the donor's basis:
- The donee simply uses the donor's carryover basis in all scenarios
- The donor's holding period always tacks on
- There is no "no man's land" zone
Inherited vs. Gifted: Side-by-Side Comparison
| Feature | Inherited | Gifted |
|---|---|---|
| Cost basis | FMV at date of death (stepped up/down) | Donor's basis (gain) or FMV at gift (loss) |
| Holding period | Always long-term | Tacks on (gain) or starts fresh (loss) |
| Unrealized gains | Eliminated by step-up | Carried over to recipient |
| Tax benefit | Significant (wipes out decades of gains) | Moderate (defers gains) |
Memory Aid: Death = Delete the gain. Gift = Grandfather the basis.
Inherited assets get a step-up to FMV at death (capital gains erased = "deleted"). Gifted assets carry over the donor's basis (the gift "grandfathers in" the original cost). Two opposite outcomes from how the security was transferred.
Exam Tip: Gotchas
- The dual basis rule only applies to gifts of depreciated property (FMV at gift < donor's basis). If FMV at gift >= donor's basis, the donee simply uses carryover basis in all scenarios.
- Inherited = stepped up; gifted = carried over. These two basis methods are commonly confused on the exam. Inherited basis resets to FMV at death, while gifted basis carries over from the donor.