The Basis Trap Of Gifting Depreciated Assets

Much of family wealth planning is predicated on the concept that assets appreciate over time.

However, over the past several years planners have often found themselves in a world made up of depreciated or "loss" assets. While these depressed values, along with historically low interest rates and favorable legislation, have presented great wealth transfer opportunities, what can easily be overlooked in these transactions is a potentially important income tax consideration, namely basis. As a result, without careful planning, the ability to recover an economic loss, at least in part, could be jeopardized.

The rule governing the basis of gifted assets is commonly referred to as the carry-over basis rule. In the case of loss assets however, this short-hand is misleading. Although a gift of appreciated property will cause the donee's basis to be the same as the donor's (with adjustments for any gift or generation-skipping transfer (GST) tax paid), a donor may not gift a tax loss. Thus, any gift of depreciated property will trigger the so-called dual basis rules under Section 1015(a). This section states, in pertinent part, that for property acquired by gift, "the basis shall be the same as it would be in the hands of the donor...except that if such basis is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value."

By way of example, assume a taxpayer gifts stock with a basis of $7 million and a fair market value of $5 million, the current gift tax exemption. If the donee later sells the stock for $8 million, the stock basis is $7 million and the gain is $1 million. If, however, at the time of the sale the stock price is $4 million, the basis would be $5 million and only a $1 million loss is recognized. If the stock is sold for a price between $5 million and $7 million, the basis would equal the date-of-gift value resulting in neither gain nor loss. In this example, if sold at $5 million, the $2 million of economic loss could not be deducted. A similar, if not more confused, result could occur in more complex transactions such as a gift to a grantor retained annuity trust (GRAT).

A GRAT is a transaction whereby a grantor gifts property to a trust but retains an annuity interest in that trust. Because of this retained interest, the GRAT can be structured so that the net gift is valued near zero. Once the GRAT terminates, provided the grantor is...