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. Carryover basis is often used when one party gifts assets or property to another person, the basis often remains the same as when the giver held the asset, adjusted for any gift taxes that were paid.

Note that the carryover basis differs from a step-up basis because carryover basis is used during the lifetime of the giver, while a step-up basis is used in inheritance 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.

Key Takeaways

  • A carryover basis refers to the cost basis for an asset received from another individual.
  • In general, the carryover basis is the same as the original cost basis.
  • Depending on whether the asset was transferred as a gift or by way of inheritance will affect its taxable status and basis calculation.

Using the correct cost basis—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 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 use the higher tax basis, you could end up paying taxes twice on the amount.

In the event the shares were 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.

Educational expenses are excluded from the gift tax, which means grandparents can pay for their grandchildren’s tuition without being penalized by the IRS.

In terms of estate planning, the carryover basis is calculated when initially earmarking assets or other property to one's future heirs. The carryover basis helps determine the initial value of one's estate and so helps determine the tax rate that benefactors or their heirs 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 of the carryover basis. 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 gift giver 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.

In 2020, the gift tax maximum is $15,000. This means that an individual may give 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.

Broken down, this means that an estate of $11 million would not be required to file a tax return, and would be exempt from paying an estate tax. 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.