Income and Assets · Property, real and personal

Basis of assets

Basis looks like the simplest topic in the outline and produces more wrong answers than almost any other, for two reasons. Gifted property that has fallen in value carries two bases at the same time — one for gain, one for loss — and a sale between them produces nothing at all. And basis falls by depreciation the taxpayer was allowed or allowable, so a client who never claimed a deduction has still lost the basis.

The rule

The starting point is cost. The basis of property is its cost, except as otherwise provided (IRC § 1012(a)); cost does not include an amount for real property taxes treated under § 164(d) as imposed on the taxpayer (§ 1012(b)). Adjusted basis for determining gain or loss is that basis adjusted as provided in § 1016 (IRC § 1011(a)).

Depreciation reduces basis whether or not it was claimed. Basis is adjusted for exhaustion, wear and tear, obsolescence, amortisation and depletion to the extent allowed and producing a reduction in tax — but not less than the amount allowable (IRC § 1016(a)(2)(A), (B) and its closing text). Where no depreciation method was adopted, the allowable amount is computed under the straight line method. The consequence is unforgiving: the deduction is lost and the basis is gone too.

A gift carries the donor’s basis, with a trap for depreciated property. The basis is the same as it would be in the hands of the donor, except that if that basis, adjusted for the period before the gift, exceeds fair market value at the time of the gift, then for the purpose of determining loss the basis is that fair market value (IRC § 1015(a)). The donee therefore holds two bases: the carryover for gain, the lower fair market value for loss. A sale at a price between them produces neither gain nor loss.

The donor’s basis must be found, not assumed. Where the facts are unknown to the donee, the Secretary is directed to obtain them from the donor, the last preceding owner, or anyone cognizant of them; only where that proves impossible is fair market value at the donor’s acquisition substituted (§ 1015(a), second and third sentences).

Gift tax paid adds to basis, in a fraction. Basis is increased by the gift tax paid, but not above fair market value at the time of the gift (IRC § 1015(d)(1)(A)). For gifts after 31 December 1976, the increase is only the portion of that tax which the net appreciation bears to the amount of the gift, net appreciation being the excess of fair market value over the donor’s adjusted basis immediately before the gift (§ 1015(d)(6)(A), (B)).

Property acquired from a decedent takes one of four measures. Fair market value at the date of death; or the value at the applicable valuation date where an alternate valuation election is made under § 2032; or the § 2032A special-use value; or the decedent’s basis to the extent of the § 2031(c) exclusion (IRC § 1014(a)(1)–(4)). The first is the default and the others are elections or special regimes — a question that says only “fair market value at death” is describing the default, not the whole rule.

And it is capped by what the estate reported. Basis under § 1014(a) cannot exceed the final value determined for estate tax purposes, or the value in a statement furnished under § 6035(a) (IRC § 1014(f)(1)). This consistency rule applies only where including the property increased the estate’s chapter 11 liability net of credits (§ 1014(f)(2)) — so it does not bite on an estate below the filing threshold.

Community property is stepped on both halves. Where at least one-half of the whole community interest was includible in the decedent’s gross estate, the surviving spouse’s own one-half share is also treated as property acquired from the decedent (IRC § 1014(b)(6)). The whole asset takes a new basis, not half of it — the single largest difference between community property and common law states on this topic.

The deathbed gift is closed off. Where appreciated property was acquired by the decedent by gift within the one-year period ending on the date of death, and passes back to the donor or the donor’s spouse, basis is the decedent’s adjusted basis immediately before death (IRC § 1014(e)(1)). No step-up.

Spousal transfers carry basis across without limitation. No gain or loss is recognised on a transfer to a spouse, or to a former spouse incident to divorce (IRC § 1041(a)); the property is treated as acquired by gift and the transferee takes the transferor’s adjusted basis (§ 1041(b)). Note the difference from an ordinary gift: § 1041(b)(2) states the carryover flatly, with no fair market value limitation for loss.

Holding periods tack wherever basis carries. The prior holder’s period is included whenever the property takes that person’s basis in whole or in part for determining gain or loss (IRC § 1223(1), (2)). And property acquired from a decedent whose basis is determined under § 1014 is treated as held for more than one year even if sold within a year of the death (§ 1223(9)).

Current figures

How it works in practice

For a gift, ask two questions before anything else: what was the donor’s adjusted basis, and what was the property worth on the date of the gift. If basis is at or below value, there is one basis and the rest is arithmetic. If basis exceeds value, write down both figures and keep them, because the answer to “what is my basis” is genuinely “it depends what you sell it for”.

For inherited property, get the estate tax return before quoting a figure. Where one was filed and the inclusion increased the tax, § 1014(f) caps basis at the reported value, and the § 6035(a) statement is the document that tells the beneficiary what that value was. Where no return was required, the cap does not apply and the ordinary § 1014(a)(1) valuation governs.

For depreciable property, reconstruct the depreciation history rather than accepting the client’s figure. Section 1016(a)(2) reduces basis by the allowable amount regardless of what was claimed, and where no method was ever adopted the allowable amount is straight line. A missed year is not a saved deduction; it is a lost one, and the basis went with it.

How this has changed

The consistency requirement is the newest layer and the one most often missing from older material. Before § 1014(f) and the § 6035(a) reporting that supports it, a beneficiary’s basis and the estate’s reported value were determined independently, and nothing stopped a low estate valuation being paired with a high income tax basis. The cap closed that, but only where the inclusion actually increased the estate’s chapter 11 liability — a condition that keeps it out of the great majority of estates.

Two paragraphs of § 1014(b) were repealed in 2014 — the former paragraphs (7) and (8), covering a surviving spouse’s community property share for deaths between 1942 and 1947 and certain joint and survivor annuity interests for deaths between 1950 and 1953. They are struck from the current text. Material that cites § 1014(b)(7) for the community property rule is citing a repealed provision: the live one is § 1014(b)(6).

The gift tax add-back has been a fraction since 1976 and is still widely stated as the whole tax. Section 1015(d)(1)(A) allows the gift tax paid, capped at fair market value; § 1015(d)(6)(A) then limits it to the tax multiplied by the ratio of net appreciation to the amount of the gift. For a gift of property with little appreciation, almost none of the tax is added.

Section 1041 replaced a rule under which a transfer to a spouse could be a taxable exchange, and it did so by treating the transfer as a gift for the whole subtitle. That drafting choice is why the transferee takes a carryover basis and why the holding period tacks under § 1223(2) — both follow from § 1041(b)(1) rather than from anything in § 1041 about basis directly.

Exam focus

Expect the dual basis fact pattern, with a sale price deliberately placed between the two figures. The answer is that neither gain nor loss is recognised, and candidates who compute only one basis will pick a number.

Expect community property as a one-word difference in the facts. It doubles the step-up.

Expect § 1014(e) dressed up as estate planning: property given to a dying relative and left back. The period is one year ending on the date of death, and the property must return to the donor or the donor’s spouse.

Watch for depreciation that was never claimed. Section 1016(a)(2) reduces basis by the allowable amount regardless.

Check yourself

1. A donor’s basis is 60,000 dollars, fair market value at the gift is 45,000 dollars, and the donee sells for 50,000 dollars. What is reported?

Answer: Nothing. The basis for gain is the 60,000-dollar carryover and the basis for loss is the 45,000-dollar fair market value under IRC § 1015(a), so a sale between the two figures produces neither gain nor loss.

2. A beneficiary sells inherited stock two months after the death. Is the gain short-term?

Answer: No. IRC § 1223(9) treats property acquired from a decedent whose basis is determined under § 1014 as held for more than one year, so any gain is long-term.

3. A taxpayer inherits a rental property valued at 900,000 dollars on the estate tax return, on which the estate paid tax. May the beneficiary use a higher appraised value as basis?

Answer: No. IRC § 1014(f)(1)(A) caps basis at the final value determined for estate tax purposes, and § 1014(f)(2) makes the cap applicable because the inclusion increased the estate’s chapter 11 liability.

4. A husband transfers stock with a basis of 20,000 dollars and a value of 12,000 dollars to his wife incident to divorce. What is her basis?

Answer: 20,000 dollars. IRC § 1041(b)(2) gives the transferee the transferor’s adjusted basis with no fair market value limitation, so there is no dual basis despite the property having fallen in value.

5. A client owned a rental for nine years and claimed no depreciation at all. What is the effect on basis at sale?

Answer: Basis is reduced by the depreciation allowable, not by the nil amount allowed, under IRC § 1016(a)(2) and its closing text — computed under the straight line method where no method was adopted. The deduction is lost and the basis reduction still applies.