Basis Increase Rule and AI Warning

STUDENT QUESTION

Dear Teacher, in this Example (Jill and Mary), I had some question about the formula of basis increase. I checked with AI and it says:

• §1015(d)(1) requires using net appreciation ÷ amount of the gift
• “Amount of the gift” = FMV of the property transferred
• IRS examples always use FMV, not taxable gift
• Taxable gift is only used in §1015(d)(6) to allocate gift tax, not to compute the basis increase fraction
• Therefore, the denominator should be $89,000 (not $70,000 after the $19,000 deduction)

Could you please explain which one is correct?

Thank you,
SK

Example:

Question: Jill, a single individual, gifted property to Mary with a fair market value of $89,000 on the date of the gift, for which her basis was $47,000. After the annual exclusion, the gift tax value of the gift was $70,000 (i.e., the fair market value of the gift less the current year annual exclusion amount). Jill consumed her entire Basic Exclusion Amount before the gift to Mary. Gift taxes paid on the property were $28,000, calculated as 40% x $70,000. What will Mary's basis be?

Answer: Mary's basis will be $63,800, calculated as follows:

• Unrealized appreciation = $42,000 ($89,000 − $47,000)
• Taxable gift = $70,000 ($89,000 − $19,000)
• Gift tax paid = $28,000 (40% of the taxable gift)
• ($42,000 ÷ $70,000) × $28,000 = $16,800

Accordingly, the donee's (Mary's) adjusted basis in the gifted property is $63,800, calculated as the donor's (Jill's) carryover basis of $47,000 plus a pro-rata portion of gift taxes paid by the donor (Jill) of $16,800.