First, one must determine its basis.
If you received property as a gift, having paid neither money nor other property for it, your cost basis would not be $0. Instead, you would use what is referred to as a substituted basis of the property.
The general rule is that the basis for determining gain on property received by gift is the same as the basis in the hands of the donor (subject to an adjustment for gift tax paid on the gift, if applicable).
If the donor also received the property by gift, then the basis is the same as that in the hands of the last preceding owner who did not acquire it by gift.
Below are two examples to help understand the basis of property acquired by gift:
In 2014, Arnold gave shares of stock worth $400 to Mitch. The stock had cost Arnold $600. This year, Mitch sells the stock for $750. Because the sale resulted in a gain, the basis is $600 (the same as in the hands of the donor). Mitch realizes a recognized gain of $150.
In 2004, Lamar purchased securities for $2,000. In 2005, when the securities had a fair market value of $3,000, he gave them to his brother, Bob. In 2009, when the stock had a fair market value of $5,500, Bob gave them to his son, Charles. Charles sold them in 2016 for $7,000.
Because Bob acquired the securities by gift, Charles’s basis would be $2,000, the same as in the hands of Lamar, and Charles will have to report a gain of $5,000.
Loss on Property Acquired by Gift
The basis for determining loss on gifts is either the same as it was in the hands of the donor (or of the last preceding owner who did not acquire it by gift) or the fair market value of the property at the time of the gift, whichever is lower.
In 2013, Aaron gave shares of stock, which cost him $550, to Ben. At the time of the gift they were worth $400. Ben sold the shares in 2016 for $300. Because the sale resulted in a loss, the basis would be $400 (the fair market value on the date of the gift). Of course, this amount is less than the basis in the hands of the donor ($550). Ben will incur a recognized loss of $100.
In 2013, Aaron gave securities that had cost him $100,000 to Ben. At the time of the gift the fair market value was $90,000. Ben sold the securities in 2016 for $95,000. In such case, there is no gain or loss. Because the basis for determining loss is $90,000 and, because the basis for determining gain is $100,000 there is no loss or gain.
The purpose of this special provision is to prevent taxpayers from gaining a tax benefit by transferring property to persons who can take advantage of tax losses.
The Basis Determining Gain: Donor’s basis (plus gift tax paid) but not more than market value at the time of gift.
The Basis Determining Loss: Limited to lesser of donor's basis (plus gift tax paid) or fair market value at time of gift.