Gifting, Selling, or Inheriting - A Question of Basis
There are three common ways to transfer assets: transferring the asset at death (inheriting), gifting the asset, or selling the asset. Ultimately, each way will result in a new owner, but the new owner’s basis in the asset will be different, depending on the technique. Basis is an important tax consideration when planning because if the owner sells the property, the basis in the asset is subtracted from the sales proceeds to determine taxable gain or loss. This section is a general overview of how common transfer techniques affect basis. The purpose of this overview is to help you decide how to best structure your transition plan to meet the overall goals of your operation.
In the majority of situations when someone receives an asset due to the death of the previous owner, the basis in the asset for the new owner will be the fair market value of the asset on the day of death. This concept is commonly referred to as “stepped-up basis, although the basis will “step down” if the value of the asset has declined. The automatic basis adjustment generally applies to assets that are part of the decedent’s estate at death.
Retirement accounts do not received a stepped-up basis, nor does property that is considered income in respect of decedent, such as accounts receivables. Likewise, most assets held in an irrevocable trust are not part of the decedent’s estate and do not get an adjusted basis. If a decedent had an interest in a life estate at death, the property does not receive a step up in basis unless the life estate was a retained life estate granted by the decedent. In this case, the life estate property remains in the decedent’s gross estate.
Example: When Harry died, he had a life estate in a farm that was granted to him by his grandfather’s will. At his death the farm passes to Sherry, who held a remainder interest. After Harry’s death, Sherry’s basis in the farm will be the FMV of the farm at the time of Harry’s grandfather’s death. This is because the farm, in which he had a granted life estate during his life, was never part of Harry’s estate.
Example: When Harry died, he also had a life estate in a house. This life estate arose when he deeded the house, which he originally owned, to his children, retaining a life estate for himself. In this case, the basis in the hands of Harry’s children will be the FMV of the house on the date of Harry’s death. This is because the house, in which he had a retained life estate, is included in Harry’s estate.
Another interesting wrinkle to the general rule is the alternative valuation date election under IRC§ 2032. This alternative is only allowed if estate tax is owed and lessened by using the alternate valuation. If the alternate valuation date is elected, the new valuation date will be six months after the date of death and will apply to all assets in the estate (i.e., you cannot pick certain assets to receive the later valuation date).
Finally, the step-up in basis depends on how the property is titled. If, for example, land was owned by an individual, the full parcel receives the stepped-up basis. If the land was co-owned by spouses in joint tenancy in a non-community property state, then half of the property gets a stepped-up basis at the death of the first spouse. If land was in a community property state, at least half of the value was included in the decedent’s estate and the spouse is the remaining owner, then all of the property receives a stepped-up basis at the death of the first spouse. Finally, if the land was owned in joint tenancy outside of a marriage, then the step up in basis will correspond to the decedent’s proportion of acquisition costs.
In general, the tax basis of property received as a gift will be the same as the basis of the donor or the giver of the gift. This is commonly referred to as “carry over basis”. Additionally, if any federal gift tax is paid, the amount paid will be added to the basis of the property for the new owner.
A gift, for tax purposes, is when an asset (land, equipment, business interest, etc.) is given to a donee with “detached and disinterested generosity. [i]” There is no legal test or safe harbor for determining whether the transfer qualifies for a gift; it is a fact determination made by the IRS or a court. The IRS is concerned with transactions trying to disguise themselves as gifts because the recipient will not owe federal income or self-employment tax on the value of the gift received.
You will still need to know and document the fair market value of the gift at the time you receive the gift because it may impact the tax treatment if you sell the property. [ii] If the fair market value of the asset is lower than the original owner’s basis, the new owner will use the fair market value at time of transfer to calculate a loss. If the new owner subsequently transfers the asset for a gain, then the original basis is used to calculate the gain. If the basis of the asset is lower than the fair market value at the time of transfer, then the basis will be used to calculate both gain and loss.
Even if you determine that the fair market value is more than your basis at the time of the gift, the fair market value should be documented in the event you face an IRS audit.[iii] The costs associated with the documentation are minimal in relation to the risk of being unable to prove your purported basis.
If you are contemplating gifting to a child who also works for you, you will need to clearly document why the gift qualifies as a gift at the time of transfer. IRC § 102(c) specifically states that gifts from employer to employee will result in income tax liability for the employee. Failure to document the gift could result in the IRS determining that the donee underreported their income. The same logic applies to gifts given between business owners.
The general rule for the sale of an asset is that the new owner receives a basis equal to amount paid for the asset. This is referred to as “cost basis.” Cost basis can include some types of expenses associated with the transaction. In a typical real estate transaction, for example, the amount paid by the buyer for legal fees, surveys, utility installation costs, and transfer taxes are included in the buyer’s new basis. The costs of obtaining financing and casualty insurance on the property are not included in basis. If the buyer assumes a mortgage on the property, the new basis is the amount paid, the amount of the mortgage on the property, and the allowable costs paid.
A seller calculates taxable gain by subtracting any paid transaction costs from the sales price and then subtracting basis.[iv] The seller’s basis includes any improvements that were added to the basis during the time the seller owned the property.
Property in Exchange for Services
If someone obtains an asset by rendering services in exchange, then the transaction – for tax basis purposes – is treated like a sale. The new owner will have a basis equal to the fair market value of the property.[v] The new owner will also need to report the fair market value of the asset as income.[vi] The original owner will be required to pay tax on any previously unrecognized gain on the asset.
This is best explained using an overly simplified example. Assume that Owner A has a piece of equipment with a fair market value of $30,000 and a basis of $10,000 that he transfers to Person B on the condition that Person B provides 200 hours of work for Owner A. Once Person B has completed the 200 hours of work, they receive the equipment. Person B will have a basis of $30,000 in the equipment since they will report $30,000 worth of income in the year they receive the equipment. Owner A will report $20,000 of gain on the “sale” of the tractor.
For basis purposes, if the trust is created through the original owner’s will and the asset is placed in trust after death, then the asset will have a stepped-up basis. The basis of an asset is the fair market value of the asset on the day the individual died.[vii] If the trust was created by the individual while they were alive, the basis depends on the interest the grantor retained in the trust.
The asset will generally receive a stepped-up basis at the time of the original owner’s death if the asset was placed into a trust that can be revoked, amended, altered, or terminated during the original owner’s life, otherwise known as a grantor trust.[viii] However, if the trust is irrevocable (unable to be changed) at the time the owner dies, then the assets usually do not receive a stepped-up basis. The assets in the trust will continue to have the same basis that they had prior to the original owner’s death.
[i] Felton v. Comm’n, 2018 T.C. Memo 168, pg. 17 quoting Comm’n v. Duberstein, 363 U.S. 278, 285 (1960).
[ii] For the definition of “fair market value” see IRS Regulation §20.2031-1.
[iii] IRS Reg §1.1015-1(g)
[iv] See, IRS Publication 544, pg. 3 for more detail.
[v] IRS Publication 551, pg. 7.
[vi] IRC § 83
[vii] This is the general rule. It is also possible there could be an alternative valuation date if (1) estate tax was owed by the decedent and (2) the executor elected the alternative valuation date.
[viii] IRC § 1014(b)(2); IRC § 1014(b)(3); IRS Reg § 1.1014-2(a)(2).
The Center for Agricultural Law and Taxation is a partner of the National Agricultural Law Center (NALC) at the University of Arkansas System Division of Agriculture, which serves as the nation’s leading source of agricultural and food law research and information. This material is provided as part of that partnership and is based upon work supported by the National Agricultural Library, Agricultural Research Service, U.S. Department of Agriculture.
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