A client receives a vacation home as a gift in March. Her uncle paid $240,000 for it in 1998, but the property is only worth $210,000 the day it changes hands. She sells it eight months later for $225,000. Same property, same closing statement, but her gain or loss depends on a single rule most candidates botch on first read. The dual-basis rule for gifts.
Every gain or loss on a property transaction is amount realized minus adjusted basis. Get basis wrong by a dollar and your reported gain is wrong by a dollar. Basis is also the cap on cost recovery, so you cannot depreciate more than your investment in the asset.
HIGH-FREQUENCY: When a problem gives both a "cost" and a "fair market value (FMV)," the rule for which one becomes basis depends entirely on how the property was acquired. Purchase = cost. Gift = donor's basis (with the dual-basis exception). Inheritance = FMV at death. Compensation = FMV at receipt.
Common mistakes
- Forgetting "allowed or allowable" depreciation. Skipping depreciation on a prior return does not preserve basis. The IRS reduces basis by what should have been claimed.
- Applying the dual-basis rule to inherited property. Inheritances have one basis: FMV at death. If FMV is below decedent's cost, the heir takes the stepped-down FMV, never carry the decedent's higher cost.
- Reporting the full FMV as gain on compensation property. The FMV inclusion creates basis equal to that same FMV. Only the post-receipt change produces capital gain or loss.
Bottom line
- Cost basis equals purchase price plus capitalized acquisition costs (commissions, legal fees, transfer taxes, sales tax, freight, installation).
- Adjusted basis equals cost basis plus capital improvements minus accumulated depreciation (allowed or allowable) minus casualty losses.
- Gift basis is the donor's adjusted basis (carryover) for gain and FMV at gift date for loss when FMV is below basis (the dual-basis rule); sales between the two recognize zero gain and zero loss.
- Inherited basis is FMV at date of death; the executor may elect the alternate valuation date (six months after death) only if it lowers both gross estate and estate tax.
Exam shortcut
When you see "gift," check the FMV-vs.-donor's-basis relationship before doing any computation. If FMV ≥ basis, donor's basis governs everything. If FMV < basis, you have a dual basis, and a sale price between the two is the no-man's-land zero result. When you see "inheritance," stop thinking about decedent's cost; FMV at death is the only number that matters.
The full lesson (about 4,386 words, 29 min read) adds 10 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- III.A1
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