The Basis of Gifted and Inherited Property: Carryover, Fair Value at Death, and the Dual Basis Rule That Produces Neither Gain Nor Loss

Receiving a gift is not a taxable event, and neither is inheriting. Section 102(a) of the Internal Revenue Code keeps the value of property acquired by gift, bequest, devise or inheritance out of gross income altogether. Nothing is taxed on the way in.

Everything therefore rides on one number. The recipient's basis decides what is taxed when the asset is eventually sold, and the two routes into ownership set it in opposite ways. A gift generally carries the donor's basis across, unrealised appreciation and all. Property from someone who has died is generally restated to its value at the date of death, which takes a lifetime of appreciation out of the income tax computation in one line, and a lifetime of decline just as quietly.

Between them sits the rule candidates trained outside the United States reliably get wrong. Where a gifted asset is worth less than the donor paid for it, it has two bases at once: the donor's for measuring a gain, a lower one for measuring a loss, and a sale at a price between them produces neither.

Why basis is the whole question

Three taxes can touch the same transfer and only one is the recipient's problem. Gift tax belongs to the donor, who reports it on Form 709: the IRS states that "the donor is generally responsible for paying the gift tax". Estate tax belongs to the estate, on Form 706. The recipient pays later, on a gain measured from basis.

Nothing in a Gulf accountant's working life rehearses this. The instinct of an IFRS-trained reader receiving an asset for nothing is to recognise it at what it is worth, and half the rule agrees: property from a decedent comes in at fair value. The other half does not, so a donee can be taxed on appreciation earned entirely in someone else's hands.

Gifts: the donor's basis travels with the asset

The general rule in section 1015(a) is carryover. Publication 551 states the straightforward case plainly: "If the FMV of the property is equal to or greater than the donor's adjusted basis, your basis is the donor's adjusted basis at the time you received the gift."

A father who bought shares for 40,000 gives them to his daughter when they are worth 150,000. Her basis is 40,000. She sells two years later for 180,000 and reports a gain of 140,000, of which 110,000 accrued before she owned anything: the gift moved the eventual tax from one taxpayer to another rather than cancelling it. A donee who treats the 150,000 value on the day of the gift as her starting point has applied the inheritance rule to a gift, and that single substitution is the most common error on the topic.

When fair market value is lower: one asset, two bases

The rule changes when the asset has fallen. Section 1015(a) provides that where the donor's adjusted basis is greater than the fair market value at the time of the gift, then "for the purpose of determining loss the basis shall be such fair market value". Publication 551 splits that in two: the basis for figuring gain is the donor's adjusted basis, and the basis for figuring loss is the fair market value when the gift was received.

Take a plot of land the donor bought for 100,000 and gives away when it is worth 60,000.

The donee sells for	The basis the rule makes her use	Result
130,000	100,000, the donor's adjusted basis	Gain of 30,000
45,000	60,000, the value at the date of the gift	Loss of 15,000
80,000	Both, tested in turn	Neither gain nor loss

Both figures are fixed on the day of the gift, later movement in the market does not reopen them, and the donee does not choose between them: the sale price selects one.

The zone that produces neither gain nor loss

The third row is the part worth memorising, and Publication 551 gives it in one sentence: "If you use the donor's adjusted basis for figuring a gain and get a loss, and then use the FMV for figuring a loss and have a gain, you have neither gain nor loss on the sale or disposition of the property."

Work the 80,000 sale both ways. Against the donor's basis of 100,000 it is a loss of 20,000, and that basis serves only for gains. Against the 60,000 value at the date of the gift it is a gain of 20,000, and that basis serves only for losses. Each test contradicts the basis it used, so the return reports nothing. Every price between 60,000 and 100,000 lands in the same dead zone, which is exactly as wide as the loss the donor was sitting on.

It exists because a built in loss cannot be handed to somebody else: the donor's 40,000 of decline can be used only by the person who suffered it, and only by selling. TCP examines that as a decision. A donor holding depreciated property should sell it, take the loss and gift the cash, because gifting the asset destroys the deduction for both of them.

The gift tax adjustment, and the part of it that counts

Where the donor actually paid gift tax, part of it is added to the donee's basis, and for gifts made after 1976 only the part attributable to appreciation. Publication 551 gives the arithmetic: multiply the gift tax paid by a fraction whose numerator is the net increase in value of the gift, fair market value less the donor's adjusted basis, and whose denominator is the amount of the gift, being "its value for gift tax purposes after reduction by any annual exclusion and marital or charitable deduction that applies to the gift".

Assume a donor's adjusted basis of 100,000, a value at the date of the gift of 400,000, gift tax actually paid of 60,000, and an annual exclusion already absorbed by earlier gifts to the same person that year, so the whole 400,000 is the amount of the gift. The net increase in value is 300,000, three quarters of that amount, so three quarters of the gift tax, 45,000, goes into basis, which becomes 145,000.

Three qualifications carry the questions. Section 1015(d)(1) caps the increase at fair market value on the day of the gift. The addition attaches to the carryover basis, so it does nothing for the fair value basis of a depreciated gift. And a gift received before 1977 takes the older rule, the whole gift tax paid, under the same cap. Most gifts pay no gift tax at all, so a question that wants this adjustment says the tax was paid and gives you the amount.

Inheritance: value at the date of death

Section 1014 breaks the chain instead of continuing it. The basis of property acquired from a decedent is generally its fair market value at the date of death, whatever the decedent paid, however long the decedent held it, and whether or not an estate tax return is filed at all. The appreciation of a lifetime is never taxed as income to anyone.

Two consequences are worth stating flatly. "Step up" is the wrong name for the rule: it restates in both directions, so an asset that has fallen steps down and its decline is lost to everyone. And the asymmetry is what TCP examines: appreciated property is worth more to an heir than to a donee, while depreciated property is worth more sold than transferred by either route.

In community property states the effect doubles. Publication 551: "When either spouse dies, the total value of the community property, even the part belonging to the surviving spouse, generally becomes the basis of the entire property", if at least half of it is includible in the decedent's gross estate.

The alternate valuation date

The estate may instead value the gross estate six months after the death, and the heir's basis follows whatever that produces. It is the executor's election, made on Form 706, and the instructions state that the executor "may not elect alternate valuation unless the election will decrease both the value of the gross estate and the sum (reduced by allowable credits) of the estate and GST taxes payable". Property distributed, sold, exchanged or otherwise disposed of inside the six months is valued at the date of disposition, and the election cannot be revoked. So it appears where the estate fell in value after the death, and it lowers the heir's basis along with the estate tax.

What the date of death rule does not reach

Exception	What happens to the basis
Income in respect of a decedent	Section 1014(c) excludes it. Unpaid salary, accrued interest and a traditional retirement account are amounts the decedent earned but was never taxed on, so they are taxed to whoever receives them. No new basis.
Property given to the decedent within a year of death	The rule "doesn't apply to appreciated property you receive from a decedent if you or your spouse originally gave the property to the decedent within 1 year before the decedent's death". Basis is the decedent's adjusted basis before death.
The consistency rule	Section 1014(f) requires the beneficiary's basis to be consistent with the value finally determined for estate tax purposes, which the executor reports to the IRS and to each beneficiary on Schedule A of Form 8971.

Holding periods

The clock follows the basis. Where the donee uses the donor's adjusted basis, the donor's holding period is added to hers under section 1223(2); where the fair value loss basis applies, nothing carries over. Publication 544 puts both in a line: if your basis is the giver's adjusted basis the holding period starts the "same day as giver's holding period began", and if your basis is FMV it starts the "day after date of gift". Inherited property needs no clock: "If you inherit property, you are considered to have held the property longer than 1 year."

Question	Gift	Property from a decedent
Basis for computing gain	Donor's adjusted basis	Value at the date of death, or at the alternate valuation date
Basis for computing loss	Value at the date of the gift, if lower	The same figure
Appreciation before the transfer	Preserved, and taxed to the recipient on sale	Out of the income tax computation for good
Decline before the transfer	Trapped between the two bases	Gone, and the deduction with it
Transfer tax added to basis	The part of the gift tax due to net appreciation	None. Estate tax does not increase basis
Holding period	Tacks where the basis carries over, otherwise starts at the gift	Long term however briefly it is held

How REG and TCP ask it

REG owns the computation. Area III, Federal Taxation of Property Transactions, is 5 to 15% of the section and covers basis and holding periods, the acquisition side of an asset's life. The topic arrives as a short multiple choice question asking for the recognised gain, or as one line inside a simulation where the basis feeds something else. The second is the expensive version: a wrong basis at the top moves every figure below it.

Four errors account for most of the marks lost. Using the value at the date of the gift when the asset had appreciated. Reporting a loss on a sale inside the no gain and no loss zone. Adding the whole gift tax rather than the appreciation fraction. Applying the date of death rule to a retirement account or other income in respect of a decedent.

TCP asks the same rules as decisions: which asset to gift and which to leave, whether the one year rule defeats the plan, what to do with property that has fallen. Once the basis is settled, the character of the gain is a separate question decided in its own fixed order, set out in Sections 1231, 1245 and 1250. Read the topic as foreign law rather than as accounting, the approach in studying REG without a US tax background.

Where to practise this

Two rules and a short list of exceptions, with the marks lost in selecting between them rather than in the arithmetic, is exactly the shape that worked repetition fixes. Prepito's REG course covers basis, holding periods and property transactions with practice questions, simulations and full explanations in English, and the planning side sits in the TCP course. For how the property area fits the rest of the section, see the REG study guide, or the CPA programme.

CPA questions and written explanations are in English. Prepito’s interface is available in English and Arabic, and the AI tutor can respond in either language.

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Sources: IRS Publication 551, Basis of Assets, IRS Publication 544, Sales and Other Dispositions of Assets, Instructions for Form 706, IRS frequently asked questions on gift taxes, IRS guidance on Form 8971, AICPA CPA Exam Blueprints. The basis rules are statutory and stable, but the exclusions, credits and thresholds around them are indexed and move every year, and blueprint weightings are published as ranges and revised periodically. Confirm both before you rely on a number.