Publication 550 (2007), Investment Income and Expenses

IRS Resources

4. Sales and Trades of Investment Property

Table of Contents

Introduction

This chapter explains the tax treatment of sales and trades of investment property.

Investment property. This is property that produces investment income. Examples include stocks, bonds, and Treasury bills and notes. Property used in a trade or business is not investment property.

Form 1099-B. If you sold property such as stocks, bonds, or certain commodities through a broker during the year, you should receive, for each sale, a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, or an equivalent statement from the broker. You should receive the statement by January 31 of the next year. It will show the gross proceeds from the sale. The IRS will also get a copy of Form 1099-B from the broker.

Use Form 1099-B (or an equivalent statement received from your broker) to complete Schedule D of Form 1040. For more information, see Form 1099-B transactions under Reporting Capital Gains and Losses, later.

Nominees. If someone receives gross proceeds as a nominee for you, that person will give you a Form 1099-B, which will show gross proceeds received on your behalf.

If you receive Form 1099-B that includes gross proceeds belonging to another person, see Nominees later under Reporting Capital Gains and Losses for more information.

Other property transactions. Certain transfers of property are discussed in other IRS publications. These include:

Sale of your main home, discussed in Publication 523, Selling Your Home,
Installment sales, covered in Publication 537, Installment Sales,
Various types of transactions involving business property, discussed in Publication 544, Sales and Other Dispositions of Assets,
Transfers of property at death, covered in Publication 559, Survivors, Executors, and Administrators, and
Disposition of an interest in a passive activity, discussed in Publication 925, Passive Activity and At-Risk Rules.

Topics - This chapter discusses:

What a sale or trade is,
Basis,
Adjusted basis,
Figuring gain or loss,
Nontaxable trades,
Capital gains and losses, and
How to report your gain or loss.

Useful Items - You may want to see:

Publication

551 Basis of Assets
564 Mutual Fund Distributions

Form (and Instructions)

Schedule D (Form 1040)
Capital Gains and Losses
6781
Gains and Losses From Section 1256 Contracts and Straddles
8582
Passive Activity Loss Limitations
8824
Like-Kind Exchanges

See chapter 5 for information about getting these publications and forms.

What Is a Sale or Trade?

Terms you may need to know (see Glossary):

Equity option

Futures contract

Marked to market

Nonequity option

Options dealer

Regulated futures contract

Section 1256 contract

Short sale

This section explains what is a sale or trade. It also explains certain transactions and events that are treated as sales or trades.

A sale is generally a transfer of property for money or a mortgage, note, or other promise to pay money.

A trade is a transfer of property for other property or services, and may be taxed in the same way as a sale.

Sale and purchase. Ordinarily, a transaction is not a trade when you voluntarily sell property for cash and immediately buy similar property to replace it. The sale and purchase are two separate transactions. But see Like-Kind Exchanges under Nontaxable Trades, later.

Redemption of stock. A redemption of stock is treated as a sale or trade and is subject to the capital gain or loss provisions unless the redemption is a dividend or other distribution on stock.

Dividend versus sale or trade. Whether a redemption is treated as a sale, trade, dividend, or other distribution depends on the circumstances in each case. Both direct and indirect ownership of stock will be considered. The redemption is treated as a sale or trade of stock if:

The redemption is not essentially equivalent to a dividend — see Dividends and Other Corporate Distributions in chapter 1,
There is a substantially disproportionate redemption of stock,
There is a complete redemption of all the stock of the corporation owned by the shareholder, or
The redemption is a distribution in partial liquidation of a corporation.

Redemption or retirement of bonds. A redemption or retirement of bonds or notes at their maturity generally is treated as a sale or trade. See Stocks, stock rights, and bonds and Discounted Debt Instruments under Capital or Ordinary Gain or Loss, later.

In addition, a significant modification of a bond is treated as a trade of the original bond for a new bond. For details, see Regulations section 1.1001-3.

Surrender of stock. A surrender of stock by a dominant shareholder who retains control of the corporation is treated as a contribution to capital rather than as an immediate loss deductible from taxable income. The surrendering shareholder must reallocate his or her basis in the surrendered shares to the shares he or she retains.

Trade of investment property for an annuity. The transfer of investment property to a corporation, trust, fund, foundation, or other organization, in exchange for a fixed annuity contract that will make guaranteed annual payments to you for life, is a taxable trade. If the present value of the annuity is more than your basis in the property traded, you have a taxable gain in the year of the trade. Figure the present value of the annuity according to factors used by commercial insurance companies issuing annuities.

Transfer by inheritance. The transfer of property of a decedent to the executor or administrator of the estate, or to the heirs or beneficiaries, is not a sale or other disposition. No taxable gain or deductible loss results from the transfer.

Termination of certain rights and obligations. The cancellation, lapse, expiration, or other termination of a right or obligation (other than a securities futures contract) with respect to property that is a capital asset (or that would be a capital asset if you acquired it) is treated as a sale. Any gain or loss is treated as a capital gain or loss.

This rule does not apply to the retirement of a debt instrument. See Redemption or retirement of bonds, earlier.

Worthless Securities

Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long-term or short-term. See Holding Period, later.

If you are a cash basis taxpayer and make payments on a negotiable promissory note that you issued for stock that became worthless, you can deduct these payments as losses in the years you actually make the payments. Do not deduct them in the year the stock became worthless.

How to report loss. Report worthless securities on Schedule D (Form 1040), line 1 or line 8, whichever applies. In columns (c) and (d), enter “Worthless.” Enter the amount of your loss in parentheses in column (f).

Filing a claim for refund. If you do not claim a loss for a worthless security on your original return for the year it becomes worthless, you can file a claim for a credit or refund due to the loss. You must use Form 1040X, Amended U.S. Individual Income Tax Return, to amend your return for the year the security became worthless. You must file it within 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later. (Claims not due to worthless securities or bad debts generally must be filed within 3 years from the date a return is filed, or 2 years from the date the tax is paid, whichever is later.) For more information about filing a claim, see Publication 556, Examination of Returns, Appeal Rights, and Claims for Refund.

Constructive Sales of Appreciated Financial Positions

You are treated as having made a constructive sale when you enter into certain transactions involving an appreciated financial position (defined later) in stock, a partnership interest, or certain debt instruments. You must recognize gain as if the position were disposed of at its fair market value on the date of the constructive sale. This gives you a new holding period for the position that begins on the date of the constructive sale. Then, when you close the transaction, you reduce your gain (or increase your loss) by the gain recognized on the constructive sale.

Constructive sale. You are treated as having made a constructive sale of an appreciated financial position if you:

Enter into a short sale of the same or substantially identical property,
Enter into an offsetting notional principal contract relating to the same or substantially identical property,
Enter into a futures or forward contract to deliver the same or substantially identical property (including a forward contract that provides for cash settlement), or
Acquire the same or substantially identical property (if the appreciated financial position is a short sale, an offsetting notional principal contract, or a futures or forward contract).

You are also treated as having made a constructive sale of an appreciated financial position if a person related to you enters into a transaction described above with a view toward avoiding the constructive sale treatment. For this purpose, a related person is any related party described under Related Party Transactions, later in this chapter.

Exception for nonmarketable securities. You are not treated as having made a constructive sale solely because you entered into a contract for sale of any stock, debt instrument, or partnership interest that is not a marketable security if it settles within 1 year of the date you enter into it.

Exception for certain closed transactions. Do not treat a transaction as a constructive sale if all of the following are true.

You closed the transaction on or before the 30th day after the end of your tax year.
You held the appreciated financial position throughout the 60-day period beginning on the date you closed the transaction.
Your risk of loss was not reduced at any time during that 60-day period by holding certain other positions.

If a closed transaction is reestablished in a substantially similar position during the 60-day period beginning on the date the first transaction was closed, this exception still applies if the reestablished position is closed before the 30th day after the end of your tax year in which the first transaction was closed and, after that closing, (2) and (3) above are true.

This exception also applies to successive short sales of an entire appreciated financial position. For more information, see Revenue Ruling 2003-1 in Internal Revenue Bulletin 2003-3. This bulletin is available at www.irs.gov/pub/irs-irbs/irb03-03.pdf.

Appreciated financial position. This is any interest in stock, a partnership interest, or a debt instrument (including a futures or forward contract, a short sale, or an option) if disposing of the interest would result in a gain.

Exceptions. An appreciated financial position does not include the following.

Any position from which all of the appreciation is accounted for under marked to market rules, including section 1256 contracts (described later under Section 1256 Contracts Marked to Market).
Any position in a debt instrument if:
1. The position unconditionally entitles the holder to receive a specified principal amount,
2. The interest payments (or other similar amounts) with respect to the position are payable at a fixed rate or a variable rate described in Regulations section 1.860G-1(a)(3), and
3. The position is not convertible, either directly or indirectly, into stock of the issuer (or any related person).
Any hedge with respect to a position described in (2).

Certain trust instruments treated as stock. For the constructive sale rules, an interest in an actively traded trust is treated as stock unless substantially all of the value of the property held by the trust is debt that qualifies for the exception to the definition of an appreciated financial position (explained in (2) above).

Sale of appreciated financial position. A transaction treated as a constructive sale of an appreciated financial position is not treated as a constructive sale of any other appreciated financial position, as long as you continue to hold the original position. However, if you hold another appreciated financial position and dispose of the original position before closing the transaction that resulted in the constructive sale, you are treated as if, at the same time, you constructively sold the other appreciated financial position.

Section 1256 Contracts Marked to Market

If you hold a section 1256 contract at the end of the tax year, you generally must treat it as sold at its fair market value on the last business day of the tax year.

Section 1256 Contract

A section 1256 contract is any:

Regulated futures contract,
Foreign currency contract,
Nonequity option,
Dealer equity option, or
Dealer securities futures contract.

Regulated futures contract. This is a contract that:

Provides that amounts that must be deposited to, or can be withdrawn from, your margin account depend on daily market conditions (a system of marking to market), and
Is traded on, or subject to the rules of, a qualified board of exchange. A qualified board of exchange is a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, any board of trade or exchange approved by the Secretary of the Treasury, or a national securities exchange registered with the Securities and Exchange Commission.

Foreign currency contract. This is a contract that:

Requires delivery of a foreign currency that has positions traded through regulated futures contracts (or settlement of which depends on the value of that type of foreign currency),
Is traded in the interbank market, and
Is entered into at arm's length at a price determined by reference to the price in the interbank market.

Bank forward contracts with maturity dates that are longer than the maturities ordinarily available for regulated futures contracts are considered to meet the definition of a foreign currency contract if the above three conditions are satisfied.

Special rules apply to certain foreign currency transactions. These transactions may result in ordinary gain or loss treatment. For details, see Internal Revenue Code section 988 and Regulations sections 1.988-1(a)(7) and 1.988-3.

Nonequity option. This is any listed option (defined later) that is not an equity option. Nonequity options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (such as the Standard and Poor's 500 index).

Warrants based on a stock index that are economically, substantially identical in all material respects to options based on a stock index are treated as options based on a stock index.

Cash-settled options. Cash-settled options based on a stock index and either traded on or subject to the rules of a qualified board of exchange are nonequity options if the Securities and Exchange Commission (SEC) determines that the stock index is broad based.

This rule does not apply to options established before the SEC determines that the stock index is broad based.

Listed option. This is any option that is traded on, or subject to the rules of, a qualified board or exchange (as discussed earlier under Regulated futures contract). A listed option, however, does not include an option that is a right to acquire stock from the issuer.

Dealer equity option. This is any listed option that, for an options dealer:

Is an equity option,
Is bought or granted by that dealer in the normal course of the dealer's business activity of dealing in options, and
Is listed on the qualified board of exchange where that dealer is registered.

An “options dealer” is any person registered with an appropriate national securities exchange as a market maker or specialist in listed options.

Equity option. This is any option:

To buy or sell stock, or
That is valued directly or indirectly by reference to any stock or narrow-based security index.

Equity options include options on a group of stocks only if the group is a narrow-based stock index.

Dealer securities futures contract. For any dealer in securities futures contracts or options on those contracts, this is a securities futures contract (or option on such a contract) that:

Is entered into by the dealer (or, in the case of an option, is purchased or granted by the dealer) in the normal course of the dealer's activity of dealing in this type of contract (or option), and
Is traded on a qualified board or exchange (as defined under Regulated futures contract, earlier.)

A securities futures contract that is not a dealer securities futures contract is treated as described later under Securities Futures Contracts.

Marked to Market Rules

A section 1256 contract that you hold at the end of the tax year will generally be treated as sold at its fair market value on the last business day of the tax year, and you must recognize any gain or loss that results. That gain or loss is taken into account in figuring your gain or loss when you later dispose of the contract, as shown in the example under 60/40 rule, below.

Hedging exception. The marked to market rules do not apply to hedging transactions. See Hedging Transactions, later.

60/40 rule. Under the marked to market system, 60% of your capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss. This is true regardless of how long you actually held the property.

Example.

On June 23, 2006, you bought a regulated futures contract for $50,000. On December 31, 2006 (the last business day of your tax year), the fair market value of the contract was $57,000. You recognized a $7,000 gain on your 2006 tax return, treated as 60% long-term and 40% short-term capital gain.

On February 2, 2007, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2006 return, you recognize a $1,000 loss ($57,000 - $56,000) on your 2007 tax return, treated as 60% long-term and 40% short-term capital loss.

Limited partners or entrepreneurs. The 60/40 rule does not apply to dealer equity options or dealer securities futures contracts that result in capital gain or loss allocable to limited partners or limited entrepreneurs (defined later under Hedging Transactions). Instead, these gains or losses are treated as short term.

Terminations and transfers. The marked to market rules also apply if your obligation or rights under section 1256 contracts are terminated or transferred during the tax year. In this case, use the fair market value of each section 1256 contract at the time of termination or transfer to determine the gain or loss. Terminations or transfers may result from any offsetting, delivery, exercise, assignment, or lapse of your obligation or rights under section 1256 contracts.

Loss carryback election. An individual having a net section 1256 contracts loss (defined later) for 2007 can elect to carry this loss back 3 years, instead of carrying it over to the next year. See How To Report, later, for information about reporting this election on your return.

The loss carried back to any year under this election cannot be more than the net section 1256 contracts gain in that year. In addition, the amount of loss carried back to an earlier tax year cannot increase or produce a net operating loss for that year.

The loss is carried to the earliest carryback year first, and any unabsorbed loss amount can then be carried to each of the next 2 tax years. In each carryback year, treat 60% of the carryback amount as a long-term capital loss and 40% as a short-term capital loss from section 1256 contracts.

If only a portion of the net section 1256 contracts loss is absorbed by carrying the loss back, the unabsorbed portion can be carried forward, under the capital loss carryover rules, to the year following the loss. (See Capital Losses under Reporting Capital Gains and Losses, later.) Figure your capital loss carryover as if, for the loss year, you had an additional short-term capital gain of 40% of the amount of net section 1256 contracts loss absorbed in the carryback years and an additional long-term capital gain of 60% of the absorbed loss. In the carryover year, treat any capital loss carryover from losses on section 1256 contracts as if it were a loss from section 1256 contracts for that year.

Net section 1256 contracts loss. This loss is the lesser of:

The net capital loss for your tax year determined by taking into account only the gains and losses from section 1256 contracts, or
The capital loss carryover to the next tax year determined without this election.

Net section 1256 contracts gain. This gain is the lesser of:

The capital gain net income for the carryback year determined by taking into account only gains and losses from section 1256 contracts, or
The capital gain net income for that year.

Figure your net section 1256 contracts gain for any carryback year without regard to the net section 1256 contracts loss for the loss year or any later tax year.

Traders in section 1256 contracts. Gain or loss from the trading of section 1256 contracts is capital gain or loss subject to the marked to market rules. However, this does not apply to contracts held for purposes of hedging property if any loss from the property would be an ordinary loss.

Treatment of underlying property. The determination of whether an individual's gain or loss from any property is ordinary or capital gain or loss is made without regard to the fact that the individual is actively engaged in dealing in or trading section 1256 contracts related to that property.

How To Report

If you disposed of regulated futures or foreign currency contracts in 2007 (or had unrealized profit or loss on these contracts that were open at the end of 2006 or 2007), you should receive Form 1099-B, or an equivalent statement, from your broker.

Form 6781. Use Part I of Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report your gains and losses from all section 1256 contracts that are open at the end of the year or that were closed out during the year. This includes the amount shown in box 11 of Form 1099-B. Then enter the net amount of these gains and losses on Schedule D (Form 1040). Include a copy of Form 6781 with your income tax return.

If the Form 1099-B you receive includes a straddle or hedging transaction, defined later, it may be necessary to show certain adjustments on Form 6781. Follow the Form 6781 instructions for completing Part I.

Loss carryback election. To carry back your loss under the election procedures described earlier, file Form 1040X or Form 1045, Application for Tentative Refund, for the year to which you are carrying the loss with an amended Form 6781 and an amended Schedule D attached. Follow the instructions for completing Form 6781 for the loss year to make this election.

Hedging Transactions

The marked to market rules, described earlier, do not apply to hedging transactions. A transaction is a hedging transaction if both of the following conditions are met.

You entered into the transaction in the normal course of your trade or business primarily to manage the risk of:
1. Price changes or currency fluctuations on ordinary property you hold (or will hold), or
2. Interest rate or price changes, or currency fluctuations, on your current or future borrowings or ordinary obligations.
You clearly identified the transaction as being a hedging transaction before the close of the day on which you entered
into it.

This hedging transaction exception does not apply to transactions entered into by or for any syndicate. A syndicate is a partnership, S corporation, or other entity (other than a regular corporation) that allocates more than 35% of its losses to limited partners or limited entrepreneurs. A limited entrepreneur is a person who has an interest in an enterprise (but not as a limited partner) and who does not actively participate in its management. However, an interest is not considered held by a limited partner or entrepreneur if the interest holder actively participates (or did so for at least 5 full years) in the management of the entity, or is the spouse, child (including a legally adopted child), grandchild, or parent of an individual who actively participates in the management of the entity.

Hedging loss limit. If you are a limited partner or entrepreneur in a syndicate, the amount of a hedging loss you can claim is limited. A “hedging loss” is the amount by which the allowable deductions in a tax year that resulted from a hedging transaction (determined without regard to the limit) are more than the income received or accrued during the tax year from this transaction.

Any hedging loss that is allocated to you for the tax year is limited to your taxable income for that year from the trade or business in which the hedging transaction occurred. Ignore any hedging transaction items in determining this taxable income. If you have a hedging loss that is disallowed because of this limit, you can carry it over to the next tax year as a deduction resulting from a hedging transaction.

If the hedging transaction relates to property other than stock or securities, the limit on hedging losses applies if the limited partner or entrepreneur is an individual.

The limit on hedging losses does not apply to any hedging loss to the extent that it is more than all your unrecognized gains from hedging transactions at the end of the tax year that are from the trade or business in which the hedging transaction occurred. The term “unrecognized gain” has the same meaning as defined under Straddles, later.

Sale of property used in a hedge. Once you identify personal property as being part of a hedging transaction, you must treat gain from its sale or exchange as ordinary income, not capital gain.

Self-Employment Income

Gains and losses derived in the ordinary course of a commodity or option dealer's trading in section 1256 contracts and property related to these contracts are included in net earnings from self-employment. In addition, the rules relating to contributions to self-employment retirement plans apply. For information on retirement plan contributions, see Publication 560, Retirement Plans for Small Business, and Publication 590, Individual Retirement Arrangements (IRAs).

Basis of Investment Property

Terms you may need to know (see Glossary):

Basis

Fair market value

Original issue discount (OID)

Basis is a way of measuring your investment in property for tax purposes. You must know the basis of your property to determine whether you have a gain or loss on its sale or other disposition.

Investment property you buy normally has an original basis equal to its cost. If you get property in some way other than buying it, such as by gift or inheritance, its fair market value may be important in figuring the basis.

Cost Basis

The basis of property you buy is usually its cost. The cost is the amount you pay in cash, debt obligations, or other property or services.

Unstated interest. If you buy property on a time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, minus the amount considered to be unstated interest. You generally have unstated interest if your interest rate is less than the applicable federal rate. For more information, see Unstated Interest and Original Issue Discount (OID) in Publication 537.

Basis Other Than Cost

There are times when you must use a basis other than cost. In these cases, you may need to know the property's fair market value or the adjusted basis of the previous owner.

Fair market value. This is the price at which the property would change hands between a buyer and a seller, neither being forced to buy or sell and both having reasonable knowledge of all the relevant facts. Sales of similar property, around the same date, may be helpful in figuring fair market value.

Property Received for Services

If you receive investment property for services, you must include the property's fair market value in income. The amount you include in income then becomes your basis in the property. If the services were performed for a price that was agreed to beforehand, this price will be accepted as the fair market value of the property if there is no evidence to the contrary.

Restricted property. If you receive, as payment for services, property that is subject to certain restrictions, your basis in the property generally is its fair market value when it becomes substantially vested. Property becomes substantially vested when it is transferable or is no longer subject to substantial risk of forfeiture, whichever happens first. See Restricted Property in Publication 525 for more information.

Bargain purchases. If you buy investment property at less than fair market value, as payment for services, you must include the difference in income. Your basis in the property is the price you pay plus the amount you include in income.

Property Received in Taxable Trades

If you received investment property in trade for other property, the basis of the new property is its fair market value at the time of the trade unless you received the property in a nontaxable trade.

Example.

You trade A Company stock for B Company stock having a fair market value of $1,200. If the adjusted basis of the A Company stock is less than $1,200, you have a taxable gain on the trade. If the adjusted basis of the A Company stock is more than $1,200, you have a deductible loss on the trade. The basis of your B Company stock is $1,200. If you later sell the B Company stock for $1,300, you will have a gain of $100.

Property Received in Nontaxable Trades

If you have a nontaxable trade, you do not recognize gain or loss until you dispose of the property you received in the trade. See Nontaxable Trades, later.

The basis of property you received in a nontaxable or partly nontaxable trade is generally the same as the adjusted basis of the property you gave up. Increase this amount by any cash you paid, additional costs you had, and any gain recognized. Reduce this amount by any cash or unlike property you received, any loss recognized, and any liability of yours that was assumed or treated as assumed.

Property Received From Your Spouse

If property is transferred to you from your spouse (or former spouse, if the transfer is incident to your divorce), your basis is the same as your spouse's or former spouse's adjusted basis just before the transfer. See Transfers Between Spouses, later.

Recordkeeping. The transferor must give you the records necessary to determine the adjusted basis and holding period of the property as of the date of the transfer.

Property Received as a Gift

To figure your basis in property that you received as a gift, you must know its adjusted basis to the donor just before it was given to you, its fair market value at the time it was given to you, the amount of any gift tax paid on it, and the date it was given to you.

Fair market value less than donor's adjusted basis. If the fair market value of the property at the time of the gift was less than the donor's adjusted basis just before the gift, your basis for gain on its sale or other disposition is the same as the donor's adjusted basis plus or minus any required adjustments to basis during the period you hold the property. Your basis for loss is its fair market value at the time of the gift plus or minus any required adjustments to basis during the period you hold the property.

No gain or loss. If you use the basis for figuring a gain and the result is a loss, and then use the basis for figuring a loss and the result is a gain, you will have neither a gain nor a loss.

Example.

You receive a gift of investment property having an adjusted basis of $10,000 at the time of the gift. The fair market value at the time of the gift is $9,000. You later sell the property for $9,500. You have neither gain nor loss. Your basis for figuring gain is $10,000, and $9,500 minus $10,000 results in a $500 loss. Your basis for figuring loss is $9,000, and $9,500 minus $9,000 results in a $500 gain.

Fair market value equal to or more than donor's adjusted basis. If the fair market value of the property at the time of the gift was equal to or more than the donor's adjusted basis just before the gift, your basis for gain or loss on its sale or other disposition is the donor's adjusted basis plus or minus any required adjustments to basis during the period you hold the property. Also, you may be allowed to add to the donor's adjusted basis all or part of any gift tax paid, depending on the date of the gift.

Gift received before 1977. If you received property as a gift before 1977, your basis in the property is the donor's adjusted basis increased by the total gift tax paid on the gift. However, your basis cannot be more than the fair market value of the gift at the time it was given to you.

Example 1.

You were given XYZ Company stock in 1976. At the time of the gift, the stock had a fair market value of $21,000. The donor's adjusted basis was $20,000. The donor paid a gift tax of $500 on the gift. Your basis for gain or loss is $20,500, the donor's adjusted basis plus the amount of gift tax paid.

Example 2.

The facts are the same as in Example 1 except that the gift tax paid was $1,500. Your basis is $21,000, the donor's adjusted basis plus the gift tax paid, but limited to the fair market value of the stock at the time of the gift.

Gift received after 1976. If you received property as a gift after 1976, your basis is the donor's adjusted basis increased by the part of the gift tax paid that was for the net increase in value of the gift. You figure this part by multiplying the gift tax paid on the gift by a fraction. The numerator (top part) is the net increase in value of the gift and the denominator (bottom part) is the amount of the gift.

The net increase in value of the gift is the fair market value of the gift minus the donor's adjusted basis. The amount of the gift is its value for gift tax purposes after reduction by any annual exclusion and marital or charitable deduction that applies to the gift.

Example.

In 2007, you received a gift of property from your mother. At the time of the gift, the property had a fair market value of $101,000 and an adjusted basis to her of $40,000. The amount of the gift for gift tax purposes was $89,000 ($101,000 minus the $12,000 annual exclusion), and your mother paid a gift tax of $21,000. You figure your basis in the following way:

Fair market value	$101,000
Minus: Adjusted basis	40,000
Net increase in value of gift	$61,000
Gift tax paid	$21,000
Multiplied by .685 ($61,000 ÷ $89,000)	.685
Gift tax due to net increase in value	$14,385
Plus: Adjusted basis of property to your mother	40,000
Your basis in the property	$54,385

Part sale, part gift. If you get property in a transfer that is partly a sale and partly a gift, your basis is the larger of the amount you paid for the property or the transferor's adjusted basis in the property at the time of the transfer. Add to that amount the amount of any gift tax paid on the gift, as described in the preceding discussion. For figuring loss, your basis is limited to the property's fair market value at the time of the transfer.

Gift tax information. For information on gift tax, see Publication 950, Introduction to Estate and Gift Taxes.

Property Received as Inheritance

If you inherited property, your basis in that property generally is its fair market value (its appraised value on the federal estate tax return) on:

The date of the decedent's death, or
The later alternate valuation date if the estate qualifies for, and elects to use, alternate valuation.

If no federal estate tax return was filed, use the appraised value on the date of death for state inheritance or transmission taxes.

Appreciated property you gave the decedent. Your basis in certain appreciated property that you inherited is the decedent's adjusted basis in the property immediately before death rather than its fair market value. This applies to appreciated property that you or your spouse gave the decedent as a gift during the one-year period ending on the date of death. Appreciated property is any property whose fair market value on the day you gave it to the decedent was more than its adjusted basis.

More information. See Publication 551, Basis of Assets, for more information on the basis of inherited property, including community property, property held by a surviving tenant in a joint tenancy or tenancy by the entirety, a qualified joint interest, and a farm or closely held business.

Adjusted Basis

Before you can figure any gain or loss on a sale, exchange, or other disposition of property or figure allowable depreciation, depletion, or amortization, you usually must make certain adjustments (increases and decreases) to the basis of the property. The result of these adjustments to the basis is the adjusted basis.

Adjustments to the basis of stocks and bonds are explained in the following discussion. For information about other adjustments to basis, see Publication 551.

Stocks and Bonds

The basis of stocks or bonds you own generally is the purchase price plus the costs of purchase, such as commissions and recording or transfer fees. If you acquired stock or bonds other than by purchase, your basis is usually determined by fair market value or the previous owner's adjusted basis as discussed earlier under Basis Other Than Cost.

The basis of stock must be adjusted for certain events that occur after purchase. For example, if you receive more stock from nontaxable stock dividends or stock splits, you must reduce the basis of your original stock. You must also reduce your basis when you receive nondividend distributions (discussed in chapter 1). These distributions, up to the amount of your basis, are a nontaxable return of capital.

The IRS partners with companies that offer Schedule D software that can import trades from many brokerage firms and accounting software to help you keep track of your adjusted basis in securities. To find out more, go to http://www.irs.gov/efile.

Identifying stock or bonds sold. If you can adequately identify the shares of stock or the bonds you sold, their basis is the cost or other basis of the particular shares of stock or bonds.

Adequate identification. You will make an adequate identification if you show that certificates representing shares of stock from a lot that you bought on a certain date or for a certain price were delivered to your broker or other agent.

Broker holds stock. If you have left the stock certificates with your broker or other agent, you will make an adequate identification if you:

Tell your broker or other agent the particular stock to be sold or transferred at the time of the sale or transfer, and
Receive a written confirmation of this from your broker or other agent within a reasonable time.

Stock identified this way is the stock sold or transferred even if stock certificates from a different lot are delivered to the broker or other agent.

Single stock certificate. If you bought stock in different lots at different times and you hold a single stock certificate for this stock, you will make an adequate identification if you:

Tell your broker or other agent the particular stock to be sold or transferred when you deliver the certificate to your broker or other agent, and
Receive a written confirmation of this from your broker or other agent within a reasonable time.

If you sell part of the stock represented by a single certificate directly to the buyer instead of through a broker, you will make an adequate identification if you keep a written record of the particular stock that you intend to sell.

Bonds. These methods of identification also apply to bonds sold or transferred.

Identification not possible. If you buy and sell securities at various times in varying quantities and you cannot adequately identify the shares you sell, the basis of the securities you sell is the basis of the securities you acquired first. Except for certain mutual fund shares, discussed later, you cannot use the average price per share to figure gain or loss on the sale of the shares.

Example.

You bought 100 shares of stock of XYZ Corporation in 1994 for $10 a share. In January 1995 you bought another 200 shares for $11 a share. In July 1995 you gave your son 50 shares. In December 1997 you bought 100 shares for $9 a share. In April 2007 you sold 130 shares. You cannot identify the shares you disposed of, so you must use the stock you acquired first to figure the basis. The shares of stock you gave your son had a basis of $500 (50 × $10). You figure the basis of the 130 shares of stock you sold in 2007 as follows:

50 shares (50 × $10) balance of stock bought in 1994	$ 500
80 shares (80 × $11) stock bought in January 1995	880
Total basis of stock sold in 2007	$1,380

Shares in a mutual fund or REIT. The basis of shares in a mutual fund (or other regulated investment company) or a real estate investment trust (REIT) is generally figured in the same way as the basis of other stock.

Mutual fund load charges. Your cost basis in a mutual fund often includes a sales fee, also known as a load charge. But, in certain cases, you cannot include the entire amount of a load charge in your basis if the charge gives you a reinvestment right. For more information, see Publication 564.

Choosing average basis for mutual fund shares. You can choose to use the average basis of mutual fund shares if you acquired the shares at various times and prices and left them on deposit in an account kept by a custodian or agent. The methods you can use to figure average basis are explained in Publication 564.

Undistributed capital gains. If you had to include in your income any undistributed capital gains of the mutual fund or REIT, increase your basis in the stock by the difference between the amount you included and the amount of tax paid for you by the fund or REIT. See Undistributed capital gains of mutual funds and REITs under Capital Gain Distributions in chapter 1.

Automatic investment service. If you participate in an automatic investment service, your basis for each share of stock, including fractional shares, bought by the bank or other agent is the purchase price plus a share of the broker's commission.

Dividend reinvestment plans. If you participate in a dividend reinvestment plan and receive stock from the corporation at a discount, your basis is the full fair market value of the stock on the dividend payment date. You must include the amount of the discount in your income.