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Welcome back. In this video,

we will continue looking at adjusted basis.

Recall that adjusted basis is calculated as

the original basis minus accumulated cost recovery.

For example, accumulated depreciation plus capital additions.

And we need to know how to calculate adjusted basis in

order to compare it to the amount realized upon the sale,

disposition, or exchange of an asset,

so that we can figure out our realized gain or loss.

Now, the original basis that we start with

depends on how the property was originally acquired.

In the previous video, we looked at the basis if the property was purchased.

If property was purchased,

then we use the cost basis.

In this video, we'll look at a situation where a taxpayer may

have gotten property but didn't actually buy it.

So, how can that be?

Well, there could be a situation where you have property and didn't

buy it because someone gave it to you as a gift.

Maybe a family member or someone else gave you a gift of

land or stock or other property, and then you sell it.

Well you never technically bought it,

so is your basis really zero?

Well, the IRS says it's not zero.

The IRS acknowledges that someone at some point

did buy the asset so there is some basis in that asset.

The question just becomes, how much?

If property was received as a gift,

then the basis depends on whether the donee or the recipient of

the gift recognizes a gain or loss on the subsequent disposition of the property.

So interestingly enough, we actually need to calculate two bases here,

a gain basis and a loss basis.

I'll explain each and then show you which one to use.

First, for the gain basis,

if the subsequent disposition of the property results in a gain,

the basis of the gifted property is the same as

the original donor's adjusted basis on the date of the gift,

assuming no gift tax was paid.

That is, there is carryover basis or the adjusted basis from the donor

at the time of the gift simply carries over to the donee. It's pretty straightforward.

The recipient of the gift here just takes the same tax basis as what the donor had.

Second, we have the loss basis.

If the subsequent disposition of the property results in a loss,

the basis that the donee must use is the lower of

either the donor's adjusted basis or

the fair market value of the property on the date of the gift.

What this does is the loss basis will

produce a basis that is different from the gain basis

only if the value of the property declined while the original donor held it.

So, why does the IRS do this?

Well, the reason for this loss basis rule is that the decline in

property's value while a donor held it is actually the donor's loss.

It should not transfer over to the donee to be deductible upon disposition.

In other words, if the donor wanted to deduct the loss,

the donor should have sold the property at a loss to recognize that loss.

But the donor didn't,

the donor gave it to the donee.

In this case, when the donee sells the property,

the basis is the smaller fair market value of the property on the date of the gift.

Smaller because it is less than the adjusted basis of the donor

because the property declined in value while the donor held it.

Now, there could be a peculiar case where the amount realized is

not greater than the gain basis or less than the loss basis.

If this is the case, then there's simply no gain or loss.

Another point here is on the holding period of the property.

Again, if someone gave you property,

how long did you technically hold it for for tax purposes?

Does your holding period start when you accept the gift?

Or does the holding period carry over where you can

add the holding period of the donor to your holding period too?

This holding period issue is important because when you sell an asset,

it might produce a short-term or a long-term gain or loss.

We've seen in previous videos that long-term capital gains, for example,

are taxed at preferential rates but

short-term capital gains are actually taxed at ordinary tax rates,

that is, higher tax rates than preferential rates.

Therefore, holding periods really matter in calculating the tax liability of the seller.

Here, if the gain basis is used,

then we have a carryover holding period.

That is, the holding period includes

both the donor's holding period and the donee's holding period.

It is as if the donee held it the entire time the donor held it and the donee held it.

However, if the loss basis is used,

the donee's holding period starts on the date of receiving the gift.

There is no carryover holding period here.

So, let's look at three examples of how this gain basis and loss basis work.

Now, to set up the examples,

let's use these general facts.

Rick received various gifts over the years.

In 2016, he's decided to sell the gifts.

What is the realized gain or loss from each of the following transactions?

What is Rick's holding period for each asset?

Assume no gift tax is paid on any of the transfers.

Okay, first example.

In 1956, Rick received land worth $25,000.

The donor's adjusted basis was $30,000.

Rick sells the land for $87,000 in 2016.

What is Rick's gain or loss?

And what's his holding period here?

Well, at a very high level,

to figure out Rick's gain or loss,

we need to take the sales price and subtract out the adjusted basis.

But, what is Rick's adjusted basis?

Well, we need to calculate the gain or loss using

both a gain basis and a loss basis to figure

out whether using the gain basis produces

a gain or whether using the loss basis produces a loss.

So first of all, for both calculations,

we use a sales price of $87,000.

That information is independent of the basis you use.

Now, the adjusted basis using the gain basis

equals the donor's adjusted basis or $30,000.

So using the gain basis, that is,

the donor's adjusted basis,

Rick calculates a realized gain of $57,000.

Now, let's look at the loss basis.

Here, the loss basis is the lesser of

the donor's adjusted basis or the fair market value at the time of the gift.

Well, the donor's adjusted basis was $30,000,

but the fair market value at the time of the gift was $25,000 back in 1956.

So we used $25,000 as the loss basis.

That is, while the donor held the land,

it went down in value by $5,000 or from $30,000 to $25,000.

This loss in value is the donor's loss, not Rick's loss,

so that's why we use the smaller of

the donor's adjusted basis or the fair market value at the time of the gift.

Using the loss basis, however,

produces a realized gain, a $62,000 gain.

So which basis do we use?

Well, if a gain basis produces a gain,

we use the gain basis.

If the loss basis produces a gain,

we cannot use the loss basis.

If, however, a loss basis produces a loss,

we will use the loss basis,

and if the gain basis produces a loss,

we can't use the gain basis.

The type of gain and the type of basis used must match.

So here, we cannot use the loss basis because it produces a gain.

Therefore, we'll use the gain basis,

and so the realized gain is $57,000.

What about the holding period?

Well, because we're using the gain basis, that is,

the carryover basis from the donor,

then we're allowed to use the carryover holding period too.

That is, we add the donor's holding period to Rick's holding period.

Rick held the land from 1956 to 2016 or 60 years.

But to the extent the donor held it beginning in 1956 or earlier,

we add that holding period to Rick's holding period.

So we can say that Rick's holding period is at least 60 years.

Let's look at a second example.

Let's say that in 1968,

Rick received land worth $12,000.

The donor's adjusted basis was $25,000.

Rick sells the land for $8,000 in 2016.

What is Rick's gain or loss?

What's his holding period?

Well, to figure out his gain or loss,

we need to take the sales price and subtract out his adjusted basis.

But again, what's his adjusted basis?

We need to calculate his gain basis and his loss basis to figure out whether

using the gain basis produced a gain or whether using the loss basis produced a loss.

As before, for both calculations,

we use the sales price.

Here, it's $8,000.

Again, that information is independent of the basis you use.

Now, the adjusted basis using the gain basis equals

the donor's adjusted basis or $25,000.

So using the gain basis,

that is, the donor's adjusted basis,

Rick calculates a realized loss of $17,000.

Now, let's look at the loss basis.

Here, the loss basis is the lesser of

the donor's adjusted basis or the fair market value at the time of the gift.

Well, the donor's adjusted basis was $25,000,

but the fair market value at the time of the gift was $12,000 back in 1968.

So we used $12,000 as the loss basis.

That is, while the donor held the land,

it went down in value by $13,000 or from $25,000 to $12,000.

This loss in value is the donor's loss, not Rick's loss,

so that's why we use the smaller of

the donor's adjusted basis or the fair market value at the time of the gift.

Using the loss basis produces a realized loss of $4,000.

So which basis do we use?

Well, if a gain basis produces a gain,

we use the gain basis.

If, however, a loss basis produces a loss,

we'll use the loss basis.

Again, the type of gain and the type of basis used must match.

So here, we cannot use the gain basis because it produces a loss.

Therefore, we'll use the loss basis,

and so the realized loss here is $4,000.

What about the holding period?

Well, because we're using the loss basis,

we can only count Rick's holding period.

Rick held the land from 1968 to 2016.

There is no carryover holding period.

Therefore, Rick's holding period for the land, in this case,

is 48 years exactly and no more.

Let's look at our last example.

Let's say that in 2001,

Rick received stock worth $30,000.

The donor's adjusted basis was $45,000.

Rick sells the stock for $39,000 in 2016.

What is Rick's gain or loss,

and what's his holding period?

Again, to figure out his gain or loss,

we need to take the sales price and subtract out his adjusted basis.

But what's his adjusted basis?

Again, we need to calculate his gain basis and his loss basis to figure out whether

using the gain basis produced a gain or whether using the loss basis produced a loss.

As before, for both calculations,

we start with the sales price.

Here it's $39,000.

Again, that information is independent of the basis you use.

Now, the adjusted basis using the gain basis equals

the donor's adjusted basis or $45,000.

So using the gain basis, that is,

the donor's adjusted basis,

Rick calculates a realized loss of $6,000.

Now, let's look at the loss basis.

Here, the loss basis is the lesser of

the donor's adjusted basis or the fair market value at the time of the gift.

Well, the donor's adjusted basis was $45,000,

but the market value at the time of the gift was $30,000 back in 2001.

So we used $30,000 as the loss basis.

Again, while the donor held the stock,

it went down in value by $15,000 or from $45,000 to $30,000.

This loss in value is the donor's loss, not Rick's loss,

so that's why we used the smaller of

the donor's adjusted basis or the fair market value at the time of the gift.

Using the loss basis produces a realized gain of $9,000.

So which basis do we use?

Well, if the gain basis produces a gain,

we use the gain basis.

If a loss basis produces a loss,

we'll use the loss basis.

The type of gain and the type of basis used must match.

So here, we cannot use the gain basis because it produces a loss,

but can we really use the loss basis?

Well, no, we can't use the loss basis either because the loss basis produces a gain.

So what in the world do we do?

Well, if using the gain basis produces a loss and using the loss basis produces a gain,

then we use neither.

Essentially, the basis is the sales price,

and thus there is no gain or loss.

Now, what about the holding period?

Well, because we're not producing either a gain or a loss,

then actually the holding period is irrelevant.

The holding period only comes into play if we have a short or long-term gain or loss.

Well, we don't have either a gain or loss, it's a wash,

so we can actually ignore the holding period.

So in summary, in this video we,

examined how to calculate the basis of property

that was originally obtained through a gift.

If using the gain basis or the donor's adjusted basis produces a gain, then we use it.

If using the loss basis or the smaller of the donor's adjusted basis or

fair market value at the time of the gift produces a loss, then we use it.

If using the gain basis produces a loss and using the loss basis produces a gain,

then we have neither a gain or loss.

In terms of holding periods,

if we use the gain basis,

then the holding period of the donor carries

over and has added to the holding period of the donee.

However, if the loss basis is used,

the holding period of the donor is ignored,

and we only look at the holding period of the donee.