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 alive, whatever is left in the trust passes to beneficiaries tax free. The GRAT is a grantor trust that is ignored for income tax purposes. Its assets are still treated as owned by the grantor, so one would expect that there would be no impact on basis as far as the income tax system is concerned. However, because the initial transfer to the trust is a gift, albeit a gift of nominal net value, the dual basis rule arguably could apply.

Assume the taxpayer above makes the same stock gift to a GRAT. If the dual basis rule applies and the trustee then sells the stock for $5 million, once again the $2 million economic loss could not be recognized. If the GRAT is successful and some of the stock is distributed to beneficiaries, the dual basis rule also could apply to them since the trust distribution would not impact basis. Even more problematic are the annuity payments made back to the grantor. If those payments are made in kind with the stock originally contributed to the trust, it is possible that the dual basis rule could apply to those shares in the hands of the grantor as well.

With some foresight, these potentially negative results could be avoided whether the transaction is an outright gift or one made to a trust such as a GRAT. For example, the taxpayer could first sell the asset, recognize the loss and then give the cash. Keeping in mind potential application of the wash sale rules, the asset then could be repurchased by the donee, effectively working around this issue.

Although Sec. 1015(a) applies to gifts, it should not apply to a sale to a grantor trust. By using a grantor trust, the sale is not recognized for income tax purposes and the basis remains intact.

For a variety of reasons, grantor trusts are an extremely useful tool in family wealth planning. One of the most common methods of creating a grantor trust while still avoiding estate tax inclusion is for a grantor to retain a power to substitute assets in and out of the trust for other assets of equal worth. Rather than giving loss property (that is expected to appreciate) and incurring the dual basis issue, the grantor could substitute the loss property for cash or other assets held by the grantor trust. Since the substitution is not a gift, the basis would be retained. If the asset is later sold for less than basis, the capital loss would be recognized.

A number of factors make right now an extremely favorable time for transferring wealth. While these factors should be taken advantage of, thought must be given not just to the transfer tax implications of such planning, but to the income tax implications as well. Although the tax code recognizes that individuals should have the ability to deduct economic losses, it also contains specific provisions like the dual-basis rules that can prevent a deduction in certain situations. Without proper planning, the benefit of this transfer tax planning could be reduced by a potential income tax trap that might have been avoided.