IRC 2512: The IRS Rule for Valuing Gifts

The Internal Revenue Service (IRS) maintains regulations for valuing property transfers to determine if a gift has occurred for tax purposes. These rules objectively assess whether a transfer of assets between individuals is a sale, a gift, or a combination of both. Understanding this framework is important for structuring transactions and meeting federal tax obligations. The focus is on the economic reality of the exchange, not the subjective intent of the person transferring the property.

This system ensures that property changing hands is correctly characterized, which has direct implications for gift tax liability. The IRS applies a consistent standard to prevent the mischaracterization of taxable gifts as simple, non-taxable exchanges. This valuation process is a component of federal tax administration concerning wealth transfer.

The Core Rule of Gift Valuation

The principle of gift valuation is found in Internal Revenue Code Section 2512. This rule states that if property is transferred for less than “adequate and full consideration in money or money’s worth,” a gift has been made. The amount of the gift is the difference between the value of the property transferred and the value of the consideration received.

“Adequate and full consideration” is a payment or exchange equivalent in value to the property being transferred. A gift can be created under this rule if the exchange is not balanced, regardless of the transferor’s intent, as the application focuses solely on the values involved.

For instance, if a parent sells a home with a verified value of $400,000 to their child for $200,000, the transaction is not viewed merely as a sale. The parent has made a gift to the child valued at $200,000. This amount would then be subject to gift tax rules, potentially requiring the filing of a gift tax return, Form 709.

Determining Fair Market Value

The gift calculation depends on determining the property’s Fair Market Value (FMV), as defined in Treasury Regulation 25.2512-1. FMV is the price at which property would change hands between a willing buyer and a willing seller, where neither is under compulsion and both have reasonable knowledge of relevant facts. This value must be determined on the date the gift is made.

The method for establishing FMV varies by asset type. For publicly traded securities like stocks and bonds, the FMV is the mean between the highest and lowest quoted selling prices on the date of the transfer. This information is readily available from public market data.

Valuing other assets requires specialized approaches. Real estate, for example, necessitates a formal appraisal by a qualified professional to substantiate its FMV. An interest in a closely-held business, which has no public market, requires a comprehensive business valuation involving analysis of financial statements, cash flow, and market comparables.

The Business Transaction Exception

An exception to the gift valuation rule applies to transactions in the ordinary course of business. Treasury Regulation 25.2512-8 clarifies that a transfer in a genuine business setting is considered to be for adequate and full consideration. This means a bad business deal, where property is sold for less than its value, is not automatically treated as a gift.

To qualify, a transaction must be “bona fide, at arm’s length, and free from any donative intent.” This standard requires a legitimate business deal between independent parties, and the relationship between them is scrutinized. A transaction between unrelated entities is more likely to be accepted as an arm’s length deal.

For example, a manufacturer selling obsolete inventory at a loss to an unaffiliated distributor to clear warehouse space would fall under this exception, as the loss reflects a business decision. However, if the manufacturer sold that inventory for the same low price to a company owned by their sibling, the IRS would investigate whether the transaction was a disguised gift.