The Certified Financial Planner™ exam is full of traps, curveballs and smokescreens. What seems to be an obvious answer in one question may not be so obvious in another. For example, when it comes to gifts and a donee’s basis, the rules are straightforward most of the time.
Rule #1: When the Value of a Gift is Equal to or Greater than the Donor’s Adjusted Basis
When the value of a gift is equal to or greater than the donor’s adjusted basis, the rule for calculating the donee’s basis is an easy one to remember: It’s the same as the donor’s. In other words, the basis “carry’s over” from the donor to the donee.
Years ago, Grandpa Joe bought McDonald’s stock for a total of $10,000. Recently, Grandpa Joe gave all of his McDonald’s stock to his grandson Mikey when the FMV was $17,000. A short while later, Mikey sold the stock for $19,000. Since the date-of-gift value of McDonald’s stock ($17,000) was (at least equal to or) greater than Grandpa Joe’s basis of $10,000, Mikey will simply use Grandpa Joe’s basis, or carryover basis, of $10,000 to calculate the taxable gain on his holding. In this case, Mikey will have a long-term capital gain of $9,000 (FMV of $19,000 – carryover basis of $10,000). The reason it’s a long-term capital gain is because Grandpa Joe’s holding period also transfers to Mikey.
In this case, the “formula” for calculating the donee’s basis is: Donee’s adjusted basis = Donor’s basis
Two CFP® exam specific things to remember about this formula are:
1. The FMV of the stock on the date of gift has to be at least equal to or greater than
the donee’s basis
2. No gift tax was paid by the donor
Rule #2: When Gift Tax is Paid by the Donor on a Gift
What happens to the donee’s basis if the donor pays gift tax on a gift? When this happens, a portion of the gift tax paid by the donor is added to the donee’s basis. In other words, the donee’s basis will still be the donor’s original adjusted basis PLUS a portion of the gift tax paid. On the CFP® exam, it’s important to realize that the amount that is added to the donee’s carryover basis is only in an amount that is attributable to the appreciation. Said another way, the donee only increases his basis by the gift tax paid by the donor on the the appreciation only. The appreciation is calculated simply by subtracting the donor’s basis from the FMV as of the date of the gift.
As opposed to Rule #1, the formula for calculating the donee’s basis when the donor paid gift tax is a bit more involved, but still manageable:
Donee’s New Basis = Donor’s original basis + ((FMV Gift – Old Basis) / FMV – Annual Gift Tax Exclusion, if appicable)) * Gift Tax paid by donor
Here’s the translation of the calculation: The donee’s basis is the donor’s carryover basis PLUS the gift tax that resulted from the appreciation of the asset while in the donor’s hands.
A number of years ago, Grandpa Joe bought McDonald’s stock for a total of $20,000 and gifted it to Mikey when the FMV was $100,000. Grandpa Joe paid $40,000 in gift taxes when he gave the stock to Mikey. Earlier in the year, Grandpa Joe also gave Mikey a car worth $30,000. After a few years, Mikey decided to sell the stock when it was worth $200,000. What will Mikey’s basis in the stock be?
A couple of things to note:
1. At the very least, you know that the donee’s basis will be the donor’s carryover basis because FMV of the gift was equal to or greater than the donor’s basis
2. The CFP® exam question throws in the $30,000 gift given earlier in the year; you have to understand that Grandpa already used up his annual gift tax exemption
3. You’ll need to recognize that the donee’s basis has to be more than the carryover basis because the donor paid gift taxes on the gift
Let’s refer to our equation when determining the basis on an appreciated gift whose FMV was equal to or greater than the donor’s basis as of the date of gift, and where the donor paid gift taxes:
Donee’s Basis = $20,000 + [($100,000 – $20,000) / ($100,000 – $0) x $40,000]
Donee’s Basis = $52,000
Notice that the annual exclusion was not a factor in this example and that’s because Grandpa Joe had already given Mikey a gift earlier in the same year and obviously already used the annual gift tax exemption.
The bottom line when calculating the basis on a gifted asset is when the FMV is equal to or exceeds the donor’s basis, the donee’s basis is the same as the donor’s. However, when gift tax is paid by the donor, you have to remember to add to the original basis just a portion of the gift tax paid and not the entire amount of gift tax paid. The portion of gift tax paid that is tied to the gain of the asset while in the hands of the donor needs to get tacked onto the donor’s adjusted basis to arrive at the donee’s new basis.