When a taxpayer disposes of an asset in a taxable sale or exchange, the tax payer is required to recognize income that is the positive difference between the sale price and the basis of the asset. Ordinarily, the basis of an asset is the cost of purchasing the asset, which is unknown if the asset was a gift. If the asset sold is a capital asset, it can qualify for capital gains tax treatment.
Unlike the "step-up" basis that a taxpayer gets for an asset acquired in the form of an inheritance, the basis a taxpayer gets in an asset acquired in the form of a gift is the basis in the hands of the donor or the last preceding owner who did not acquire the asset as a gift. If the gifted asset is sold or exchanged at a loss, then the basis is the lower of:
- The donor’s basis or basis of the preceding owner who did not acquire the asset as a gift, or
- The fair market value of the asset at the time of the gift.
No income or loss needs to be recognized in the special case when the taxpayer sells a depreciated gifted asset at a loss for a sale price that is below the donor’s basis and above the fair market value of the asset at the time of the gift. This special case is known as the "double basis rule."
For example, T receives a gift from B, who has a basis in the asset of $50. At the time of the gift, the fair market value of the asset is $30 (i.e the asset has depreciated). T later sells the gifted asset for $40 to an unrelated party. No income or loss needs to be recognized by T in this transaction because it is being sold for a loss according to B’s basis but still above the asset’s fair market value when B gave it to T.
If the donor paid gift taxes on an asset, then the donor’s basis of the gifted asset is affected. The taxpayer may increase the basis of the gifted asset by the amount of any federal gift tax paid in connection with the gift. Generally, the taxpayer may increase the basis of the gifted asset up to the fair market value of the asset at the time of the gift.
Ordinarily, the taxpayer will have a basis that equals to the amount that he or she paid for the asset if it was purchased from an unrelated party. No income needs to be recognized at the time of the purchase just because the taxpayer is a good at bargaining and was able to purchase an asset at a substantially low price.
If there is an employment relationship between the seller and the buyer, then there is a chance that the bargain portion of the sale (i.e the amount of fair market value in excess of the sale price) may really be compensation for the buyer’s work and that amount might be fully taxable as wages. In this case, the basis of the asset to the buyer will be:
1. The amount he or she paid for the asset, plus
2. The amount of the bargain portion that is taxable to the buyer as income.
If there is some familial or close relationship between the seller and the buyer, then the purchase may likely be considered a "part sale-part gift." The basis to the buyer in this case would be the greater of:
1. The amount paid by the buyer for the asset; or
2. The basis of the donor or the last preceding owner of the asset who did not receive the asset as a gift.
Similar to the basis rules for gifted assets, if the asset acquired in a "part sale-part gift" transaction is sold or exchanged at a loss, the basis of the asset to the donee/buyer is limited to the fair market value of the asset at the time of the gift.
Although there are various tax preparation softwares on the market that may help you with your tax problems, they cannot provide the same level of service that a tax lawyer can. If you are unsure about the basis of your gifted assets or you need someone to represent you before the IRS, a tax attorney can help you.