This is the final part of a three part series which examines sales of gifts, non-business bad debts, and securities. In the first part, we discussed the general aspects of capital gains and losses, the brokers reporting to investors, how and where they are reported on Form 1040 and supporting schedules. The previous part discussed the tax implications for wash sales stock rights, small business stock, and inheritances.

Sale of Gifts

Gain or Loss on Sale

When a taxpayer sells securities that were received as a gift, the gain or loss and holding period depends on whether they were sold for more or less than the donor’s basis (cost or other basis, plus the gift tax paid). The gift tax adjustment depends on the donor’s acquisition date. If the shares gifted were acquired by the donor between 9/2/58 and 12/31/76, the entire amount of gift tax is added to the donor’s basis. If the shares gifted were acquired by the donor after 12/31/76, a portion of the gift tax is added to the donor’s basis. The amount added is the gift tax paid multiplied by the ratio of the donor’s appreciation in value (value at date of gift less cost) divided by the value at date of the gift, less the annual gift tax exclusion ($14,000 for 2015). The gift tax adjustment applies regardless of a gain or loss on the sale.

If the donor realizes a gain (sales price is more than the donor’s basis), the donee’s basis will be the donor’s basis. The donee’s holding period will be the donor’s holding period (from date of donor’s acquisition to date of gift, plus the time held by the donee). If the donor realizes a loss (sales price is less than the donor’s basis), the donee’s basis for determining the allowable loss, is the lesser of the fair value of the securities at the date of the gift or the donor’s basis. The reason for using the value at the date of the gift, if it is less than the donor’s basis, is that the donee should not get a tax benefit (a greater loss) for a decline in value not suffered by the donee (the donor suffered the loss in value while holding the securities).

Donee’s Holding Period

This depends on whether the donor’s basis or value at date of the gift is used for the donee’s basis. If the donor’s basis is used, the holding period begins on the donor’s acquisition date. If the value at the date if the gift is used, the holding period begins on the date of the gift.

Example 1: Sale for gain-donor acquisition date before 1/1/76

Claire purchased 1,200 shares of IBM on 7/1/75 for $30,000. On 10/1/14 she makes a gift of the shares to Angelica. On that date, the value was $180,000. She paid gift tax of $1,500. The entire $1,500 gift tax is added to Claire’s basis since she purchased the shares before 1/1/76. This makes her adjusted basis $31,500. On 8/1/16, Angelica sells all the shares for $192,000. Since the shares were sold for more than the donor’s basis, Claire’s adjusted basis is used for Angelica’s basis. Angelica has a long-term capital gain of $160,500 ($192,000 – $31,500). Even though Angelica held the shares for only 10 months, the gains long-term because his holding period starts with Claire’s purchase date.

Example 2: Sale for gain-donor acquisition date after 12/31/76.

Assume the same facts as Example 1 and the gift tax annual exclusion in 1975 was $8,000. Claire’s gift tax adjustment is $1,305, the gift tax paid multiplied by the ratio of the donor’s appreciation in value divided by the value at date of the gift, less the annual gift tax exclusion: {$1,500 x [($180,000-$30,000) / ($180,000 – $8,000)]}. Angelica’s basis for gain will be $31,305 ($30,000 + $1,305) and her long-term capital gain is $160,695 ($192,000 – $31,305).

Example 3: Sale for less than donor’s basis.

On 6/30/2008, Grace purchased 500 shares of Dell for $22,500. On 12/31/15, she gives them to Joe. At that date, the shares value was $17,500. On 7/31/16, Joe sells the shares for $15,500. Since the value of the shares at the date of the gift was less than Grace’s cost, Joe must use the value at the date of the gift for his basis and the date of the gift is the start of his holding period. Joe has a short-term (holding period is seven months) capital loss of $2,000 ($17,500 – $15,500).

Sale of Inherited Property

When a taxpayer sells property received as an inheritance, the basis for determining the recipient’s gain or loss is the fair value at the date of death or the alternate valuation date, if the executor elects to use this date to value the deceased’s property for the estate tax. There is no adjustment for estate tax paid as there is for the gift tax. When securities are distributed, the executor should always provide the appropriate value to the recipient. The IRS regulations state that the holding period will always be long-term, regardless of how long they were held by the deceased and the recipient.

Example

On 7/15/15 John received 1,000 shares of IBM stock from his grandfather’s estate . His grandfather died who died on 11/15/14. His grandfather purchased the shares for $85,000 in 2002. The executor elected the fair value at date of death for estate tax purposes. At that time, the fair value was $155,000. On 12/27/16, John sold 500 shares for $87,500. John will report a long-term capital gain of $10,000 [$87,500 – (500 / 1,000 x $155,000)]. Note that even though John held the shares for only five months, the holding period is still long-term. If John sells the shares for $70,000, he will report a long-term loss of $7,500 ($77,500 – $70,000). His basis in the remaining 500 shares is $77,500 (½ x $155,000). Basis per share is $155 ($77,500/500).

Non-Business Bad Debts

A non-business bad debts is treated as a short-term capital loss, regardless of how long it has been owed to the creditor. The debt must be bona fide. If the creditor cannot substantiate that the debt is bona fide, and reasonable efforts were made to collect it, the IRS may consider it as a gift and no deduction will be allowed. This is particularly true for debts involving related parties. To be able to substantiate and validate the debt, the debt agreement should be in writing and signed and dated by the debtor and creditor. The creditor should have documentation (such as letters and records of phone calls to the debtor or a court suit) for attempts to collect it. A very good way to document the worthlessness of a debt is to obtain a court judgment against the debtor and show proof of follow-up attempts to collect the judgment. Non-business debts are not limited to loans. They could be for amounts paid on behalf of another person.

Example

On February 1, 2015, Harold purchased a computer for $1,200 for his friend Barb and made $100 monthly payments for 12 months. There was a written agreement that Barb would repay the amounts that he paid, starting in July 2015. Harold had copies of the cancelled checks for the payments. Barb did not make the payments despite many oral and written requests. On September 30, 2016, Harold sued her in small claims court and obtained a judgment for $1,200. Despite many attempts to collect the judgment Barb did not pay him. Harold was able to document the legitimacy of the debt by the written repayment agreement, cancelled checks for payments made, letters requesting payment, and the court judgment. Harold can take a $1,200 short-term capital loss in 2016.

Note: even though the debt agreement was held for 20 months (February 1, 2015 to September 30, 2016), the loss is still a short-term capital loss.

The creditor could have a partial loss if any amount has been collected from the debtor or a collection agency. If the creditor takes a capital loss for part or all of the debt and in a later year collects part or all of it, the amount recovered must be reported as ordinary income in the year received.

Example 1

Assume the same facts as above except Barb pays $800. Harold has a short term los s of $400.

Example 2

On July 15, 2017, Barb pays Harold an additional $300. Harold must report ordinary income of $300 In 2017, since a $400 loss was deducted in 2016.

Worthless Securities

A corporation may go out of business and its securities become worthless. This results in a capital loss equal to the taxpayer’s basis in the securities less any recovery. Regardless of when during the year the loss became evident, the holding period ends on the LAST day of the tax year in which the security became worthless.