There is often times confusion amongst taxpayers about the nature of gifts and inheritances, both for tax and basis purposes. They can both be misconstrued as the same thing, but they are very different. It is important to consult professional legal or tax advice regarding gifts and inheritances.
Gifts
Gifts can be made by individuals to other individuals at their discretion. Individuals can make gifts of up to $14,000 (2015) without reporting the gift. Gifts over that amount require reporting on an annual gift tax return. A recipients basis in the gift is typically the donor's adjusted basis (cost) in the gift when it is given. There are special rules when the fair market value (FMV) of a gift is less than it's adjusted basis. The recipient does not report the gift under any circumstance, unless it generates income or is sold for a gain/loss in the future.
Transfers at death (inheritance)
Transfers received as a result of an individuals death (commonly known as an inheritance) are not taxable to the recipient, and their adjusted basis is typically the FMV of the assets on the date of death. These assets only become taxable if they generate income or are sold at a gain/loss in the future. If the transfer is made into a trust, the beneficiary might be required to report the income of the trust on their individual tax return.
Application
In this scenario, let's say Sue has common stock with an adjusted basis of $10,000 and a current FMV of $13,000. She gifts this stock to her son, Bob. Sue does not file a gift tax return because the value of the gift is less than $14,000. If Bob sells the stock once he receives it, he will have a capital gain of $3,000 because of the difference in the adjusted basis and the FMV.
On the other hand, let's say Sue dies and Bob inherits the stock and immediately sells it. He will have no capital gain or loss, because the FMV of the stock at the date of death will become his adjusted basis, which is also the same when he sells it.
Taxpayers with assets they want to pass on should consult professional legal and tax advice in order to develop a gifting plan and a strong will to benefit their heirs or charitable organizations.