What Is Carryover Basis and How Does It Work?

When property is transferred as a gift, the recipient’s tax basis isn’t reset to its market value. Instead, it carries over from the original owner, affecting capital gains taxes when the asset is sold. Understanding this is crucial for both givers and recipients when considering future tax liabilities.

Property Transfers That Qualify for Carryover Basis

Certain property transfers retain the original owner’s tax basis rather than resetting to fair market value. The most common example is when an individual gifts an asset. The recipient assumes the donor’s original cost basis, including the purchase price and any adjustments such as depreciation or capital improvements. If the asset has appreciated, the recipient may face a larger taxable gain when selling it.

Carryover basis also applies to most transfers between spouses. Under Section 1041 of the Internal Revenue Code, property transferred between spouses or as part of a divorce settlement is treated as a gift, meaning the receiving spouse takes on the original basis. While this prevents immediate tax consequences, it affects future capital gains calculations.

Certain irrevocable trusts follow this rule. When assets are placed in a trust where the grantor retains no control or benefit, the beneficiary typically inherits the original basis. This differs from revocable trusts, where assets receive a step-up in basis upon the grantor’s death.

Gift Tax Interaction

Gifting property does not trigger income tax for either the giver or recipient. However, the donor may need to file a gift tax return if the value exceeds the annual exclusion limit, which is $18,000 per recipient in 2024. This exclusion allows individuals to give up to this amount to as many people as they wish without reporting it. If a gift exceeds this threshold, the excess counts toward the donor’s lifetime estate and gift tax exemption, which is $13.61 million in 2024.

Filing a gift tax return (IRS Form 709) does not necessarily mean taxes are owed. The form tracks how much of the lifetime exemption has been used. Only when total lifetime gifts exceed the exemption does the donor face gift tax liability, which can reach a maximum rate of 40%. Married couples can use gift-splitting rules to double the annual exclusion to $36,000 per recipient without filing a return.

The recipient of a gifted asset does not owe taxes at the time of transfer. Tax consequences arise only when they sell the asset. If a parent gifts stock purchased for $10,000 that is now worth $50,000, the child’s basis remains $10,000. If sold immediately, the taxable gain would be $40,000, subject to capital gains tax rates ranging from 0% to 20%, depending on income.

Holding Period Considerations

The length of time an asset is held before being sold affects how gains are taxed. With carryover basis, the recipient also inherits the original owner’s holding period. If the donor held the asset for more than a year before gifting it, the recipient’s eventual sale would be taxed at long-term capital gains rates, which are lower than short-term rates. If the donor owned the asset for less than a year, the recipient’s holding period continues from that point, potentially leading to short-term capital gains treatment if sold soon after receiving it.

Long-term capital gains are taxed at 0%, 15%, or 20%, depending on taxable income. Short-term capital gains are taxed as ordinary income, with rates as high as 37% for high earners in 2024. If an individual in the highest tax bracket receives a gifted asset purchased a few months prior, selling it immediately would result in a higher tax burden than if they waited for the long-term threshold.

If the asset’s fair market value at the time of gifting is lower than the original purchase price, calculating taxable gain or loss becomes more complex. If the recipient sells at a price above the donor’s original cost, the gain is based on the carryover basis. If it sells for less than the fair market value at the time of the gift, the loss is determined using that lower value. If the sale price falls between these two amounts, no gain or loss is recognized. This rule prevents individuals from artificially generating tax-deductible losses by gifting depreciated assets.

Record-Keeping and Reporting

Maintaining thorough documentation is necessary when dealing with carryover basis, as the recipient must establish the original owner’s cost basis. This requires records detailing the asset’s purchase price, any improvements or adjustments made over time, and relevant transactions that could affect its basis. Without proper documentation, reporting capital gains can become complicated, potentially leading to IRS challenges or an unfavorable tax outcome.

This is especially important for assets with a long history, such as real estate or closely held business interests, where records may be incomplete or difficult to obtain. If prior records are unavailable, taxpayers may need to rely on historical pricing data, appraisals, or reconstructed financial statements. IRS Publication 551 provides guidance on establishing basis when records are missing, emphasizing the importance of reasonable estimates supported by available evidence.