Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

How is the cost basis determined for a gifted stock?

1. Always based on the current market price

2. Always based on the purchase price

3. Based on the lower of either the purchase price or current value

4. Based on the higher market price

The correct answer is: Based on the lower of either the purchase price or current value

The correct answer is based on the lower of either the purchase price or current value, which accurately reflects how the cost basis for gifted stock is determined. When stocks are gifted, the recipient generally receives the donor's cost basis, which is essentially the original purchase price of the stock. However, if the stock has decreased in value since the time it was purchased, the recipient's cost basis may be adjusted to reflect the lower fair market value at the time of the gift for capital gains tax purposes. This means that if the stock was purchased for a higher price, but its current market value is lower, the recipient uses the lower value to determine their capital gains when they eventually sell the stock. This approach protects the recipient from tax liabilities on gains that wouldn’t have been realized due to depreciation in the asset's value. Therefore, the cost basis reflects the potential for loss rather than only the initial purchase price or the current market price. The other options either incorrectly state that the basis is always based on the current market price or the purchase price or suggest an erroneous notion of always using the higher market price. Understanding this principle is important for recognizing how taxes on capital gains and losses work in the context of gifted securities.