Gifts of Loss Property
Every investor knows that her portfolio will always contain winners and losers. Whether the losses will be deductible depends on a lot of things, including whether the underlying investment has been held long-term or short-term. And when the type or amount of the loss is such that it can’t be beneficially included on your own tax return the question will arise: What’s the best thing I can do with this dog?
For some investors the temptation might be to give the losing investment to a friend or relative, someone with the sorts of gains amenable to offset by the particular losses incurred by it. But this sort of loss sharing arrangement is precisely the kind the Internal Revenue Code is set up to prevent. From the IRS point of view, investment losses are inevitable and often rightly deductible. But strategically arranging and timing your losses, using them to offset the gains of your friends and relatives, is a very different matter. The gist of how the rules work can best be understood by example.
Suppose dear Uncle is holding 100 shares of XYZ stock which he purchased six months ago for $10,000. Almost immediately the shares’ value fell to $1,000, leaving Uncle with a $9,000 short-term capital loss (for more on types of capital losses go here). Unfortunately, Uncle is a long-term oriented investor and the rest of his portfolio only has long-term capital gains, which can’t be offset by these short-term losses.
Nephew, on the other hand, is a bit more of a gambler, trading in and out of the market on a daily basis. He’s been lucky this year and amassed a sizeable amount of short-term capital gains. Uncle decides to give his shares of XYZ to Nephew, thinking Nephew could sell the shares, take the loss, and realize a significant tax savings on his short-term gains. Nephew thinks that sounds like a great idea and promises to return the favor one day.
Whether their strategy is sound depends on what basis Nephew takes when Uncle gives him the stock. If the stock had appreciated in value then Nephew would take the gift with carry-over basis of $10,000, i.e., Uncle’s basis (go here for more on this point). Because the Internal Revenue Code is so opposed to the strategic timing and sharing of losses, however, there is a different set of rules for Loss property. And those rules mean Uncle and Nephew are in trouble.
Under the loss property rules, Nephew’s basis for tax purposes isn’t actually determined until he actually sells the shares of XYZ. There are three possibilities:
- he sells them for more than Uncle’s basis ($10,000)
- he sells them for less than the fair market value at the time of the gift ($1,000), or
- he sells them the for a price in between the first two
Suppose first that Nephew receives Uncle’s gift and a month later things have gone from bad to worse. Nephew sells the shares for $300. Because his amount received is smaller than the fair market value ($1,000) at the time of the gift, his basis for tax purposes is deemed to be $1,000. As a result his total short-term capital loss on the sale is just $700. He can use this to offset his short-term capital gains but it’s a far cry from what he and Uncle had hoped.
Second, imagine instead that XYZ experiences a meteoric increase in value and a month after the gift Nephew sells the shares for $12,000. Nephew’s basis for tax purposes is now deemed to be the carry-over basis ($10,000), the same as is the gifted shares had been appreciated (and not loss) property. Nephew must report a $2,000 short-term capital gain.
Finally, what if Nephew were able to sell all his newly acquired XYZ shares for a price somewhere between the fair market value and the carry-over basis, for example, say $4,000? In this case the Internal Revenue Code deems that there shall be no gain or loss recognized by Nephew. In essence, Nephew’s basis for tax purposes is deemed equal to the selling price.
For all their good intentions, then, Uncle’s attempt to pass to Nephew a $9,000 short-term capital loss by means of a gift is just not meant to be. Happily, other possibilities abound and Nephew and Uncle may yet succeed, provided they first seek the help of a good tax advisor.
This article is for informational purposes only and does not constitute legal advice. You should consult a qualified attorney before taking any action.