Gifts and Inheritances: How Tax Basis Changes
Giving property during your lifetime and leaving it to someone at death can produce very different income tax results. The difference often comes down to basis, the amount used to calculate a gain or loss when the recipient sells. A gift can carry a large unrealized gain to the next owner, while an inheritance generally receives a new basis tied to the property's value at death.
That does not make an inheritance the best choice in every case. The property's value, your need for it, and the recipient's circumstances all belong in the decision.
Compare a gift with an inheritance
For purchased property, basis generally starts with cost, including eligible purchase expenses. Improvements, depreciation, and other adjustments can change it. Keep those records because the current market value alone will not tell you the taxable gain.
Assume you bought investment land for $25,000, its value is now $250,000, and there are no other basis adjustments. Your child later sells it for $250,000 with no selling expenses:
| How your child receives the land | Child's basis | Gain on sale |
|---|---|---|
| You give it during your lifetime, with no gift-tax basis adjustment | $25,000 | $225,000 |
| Your child inherits it when its value is $250,000, under the usual inherited-property rule | $250,000 | $0 |
The gift generally carries over your adjusted basis. Inherited property generally receives fair market value at death, whether or not federal estate tax is due. This adjustment can decrease basis when property has fallen in value; it is not always a step-up.
Gifts of property that has lost value
When property is worth less than the donor's adjusted basis at the time of a gift, the recipient generally needs two basis figures: the donor's basis for measuring gain and the lower gift-date value for measuring loss.
Suppose you give investment shares with a $10,000 adjusted basis and an $8,000 fair market value. With no later adjustments or selling expenses, these results follow:
| Sale proceeds | Basis rule used | Tax result |
|---|---|---|
| $12,000 | $10,000 gain basis | $2,000 gain |
| $9,000 | Proceeds fall between the two basis figures | Neither gain nor loss |
| $7,000 | $8,000 loss basis | $1,000 loss |
Selling the shares yourself before giving cash may preserve an investment loss that a direct gift would not carry to the recipient. Capital-loss limits and wash-sale rules can affect that approach. Losses on personal-use property generally are not deductible.
Gift tax can change the calculation
For gifts made after 1976, part of the gift tax actually paid may increase the recipient's basis. The increase relates to appreciation in the property and cannot raise basis above fair market value. If the property has not appreciated, this rule does not add gift tax to basis.
The calculation uses the gift's value for gift-tax purposes after applicable annual exclusions and marital or charitable deductions. Dividing by the property's full market value can therefore give the wrong answer. A gift-tax return also does not necessarily mean tax is payable because available exclusions and credits matter. Keep the return and the donor's basis records together. The IRS basis guide explains both the gift-tax adjustment and the two-basis rule.
Exceptions to the inherited-property rule
An executor can sometimes elect alternate valuation for an estate, but it must reduce both the gross estate's value and the combined net estate and generation-skipping taxes payable because of death. Property sold or distributed within six months generally uses the earlier disposition date; other property generally uses the six-month date. This is an estate election, not a choice each beneficiary makes for individual assets. See the Form 706 instructions.
The taxable portion of an inherited traditional IRA and unreported profit in installment-sale payments are examples of income in respect of a decedent, or IRD. Those amounts do not receive the usual basis adjustment and generally are taxed when received. Recovery of existing basis and qualified Roth distributions should not be treated as taxable income merely because they are inherited. A deduction may be available for federal estate tax attributable to IRD reported in the recipient's income. The IRS guide for survivors and executors covers these rules.
Another exception applies when you give appreciated property to someone who dies within one year and leaves it back to you or your spouse. The returned property's basis generally is the decedent's adjusted basis immediately before death, rather than a new fair market value. Special valuation and basis-consistency rules can also affect inherited assets.
Trusts and generation-skipping transfers
A trust distribution does not automatically receive a new basis just because it follows a death. The trust's terms, estate inclusion, and the type of transfer matter.
Generation-skipping transfer (GST) tax can create a separate basis adjustment. Generally, after the gift basis rules apply, basis increases only by the GST tax attributable to appreciation, without exceeding fair market value. A different rule applies to a taxable termination occurring simultaneously with and because of an individual's death: basis adjusts under rules similar to the inherited-property rule, potentially up or down. If the GST inclusion ratio, the fraction subject to GST tax, is below one, the adjustment is reduced proportionally. These rules are in Internal Revenue Code section 2654.
Use both tax and family goals
A completed gift can move future appreciation out of an estate, but retained interests and other estate-inclusion rules can change that result. Federal law also adds to the gross estate gift tax paid by the decedent or the estate on gifts made by the decedent or spouse during the three years ending at death. The gift date controls that three-year test, not the tax-payment date. See section 2035.
Before transferring an asset, compare the recipient's likely tax on a sale with any estate-tax benefit. Then consider whether the recipient needs the property now, whether you can afford the gift, and whether another asset would meet the same goal. Preserve purchase and improvement records, gift-date valuations, and estate valuations so the eventual sale can be reported correctly.