Carryover Basis

What Is Carryover Basis?

Carryover basis is a method for determining the tax basis of an asset when it is transferred from one individual to another. A carryover basis is often used when one party leaves assets or property to another person as a gift. In this situation, the basis often remains the same as when the giver held the asset, but the basis may be adjusted to account for any gift taxes that were paid.

The carryover basis differs from a step-up basis. A carryover basis is used during the lifetime of the giver, while a step-up basis is used when an asset is inherited after the giver passes away. In a step-up basis scenario, the value of the assets being transferred is adjusted to its current market value.

Understanding Carryover Basis

The cost basis of an investment is the total amount originally invested, plus any commissions or fees involved in the purchase. This can either be described in terms of the dollar amount of the investment or the effective per share price of the investment.

Determining the correct cost basis of an investment — also referred to as the tax basis — is important especially if you reinvested dividends and capital gains distributions instead of taking the earnings from the investment in cash. When you reinvest dividends or distributions, the tax basis of your investment increases. This increase should be accounted for so that you can report lower capital gains, and therefore, pay fewer taxes. If you don't report the higher tax basis, you could end up paying higher taxes.

When shares are given to you as a gift, your cost basis is the cost basis of the original holder of the asset who gave you the gift. If the shares are trading at a lower price than when the shares were gifted, the lower rate is the cost basis. If the shares were given to you as part of an inheritance, the cost basis of the shares for the inheritor is the market price of the shares on the date of the original owner's death.

In the process of estate planning, the carryover basis helps determine the initial value of one's estate, so the carryover basis helps determine the tax rate that the heirs of an estate must pay on capital gains when they sell any assets associated with that estate.

Carryover Basis and Gift Taxes

Gift taxes are a critical component in determining the carryover basis of an asset. This is a federal tax that applies to scenarios in which the receiving party does not pay the giver full value for the gift (although they might pay a lesser amount).

The giver of the gift is the one that bears the brunt of the gift tax. In general, gifts to one's spouse or to a political organization, or gifts valued at less than the annual gift tax exclusion, along with medical and educational expenses, are excluded from the gift tax. For 2020 and 2021, the gift tax maximum is $15,000 per person per year. This means that an individual may gift another individual $15,000 or less per year without incurring a gift tax.

The gift tax differs from the estate tax, which is levied on an heir's inherited portion of an estate. In 2020, the exclusion limit for the estate value was combined gross assets and prior taxable gifts exceeding $11.58 million. This effectively means that an estate of $11 million would not be required to file a tax return and would be exempt from paying the estate tax. For 2021, the exemption equivalent will increase to $11.7 million per individual (or 23.4 million for a married couple).

While the estate tax is mostly imposed on assets left to heirs, it does not apply to the transfer of assets to a surviving spouse. The right of spouses to leave any amount to one another is known as the unlimited marital deduction.