When is the tax basis set for a mutual fund received as a gift?

When shares of a mutual fund are gifted from donor to donee, is the tax basis, for purposes of the donee's taxes, still set at the amount and date of the original mutual fund purchase? Or is it set at the amount and date of the gift?

Example:
Donor buys shares in 2001 for $7,000. Over time, market value rises to $12,000.
Donor gives full account (worth $12,000) to donee in October, 2007. Over time, market value drops to $10,000.
Donee sells all shares for $10,000 in February, 2008.

Does donee have a $3,000 realized gain, subject to capital gains tax?
Or does donee have a $2,000 realized loss?

If donee has a loss, does the loss reduce the donee's taxable income for 2008?
Or can the loss only be used to reduce the donee's capital gains in 2008?

Thanks for any help!

IRS publication 551, page 8.

It depends. But the basic rule is the the person receiving the gift received it WITH all the built in capital gains.

Property Received as a Gift
To figure the basis of property you receive as a gift, you must know its adjusted basis (defined earlier) to the donor just before it was given to you, its FMV at the time it was given to you, and any gift tax paid on it.


FMV Equal to or More Than Donor's Adjusted Basis
If the FMV of the property is equal to or greater than the donor's adjusted basis, your basis is the donor's adjusted basis at the time you received the gift. Increase your basis by all or part of any gift tax paid, depending on the date of the gift.

Also, for figuring gain or loss from a sale or other disposition of the property, or for figuring depreciation, depletion, or amortization deductions on business property, you must increase or decrease your basis by any required adjustments to basis while you held the property. See Adjusted Basis, earlier.

your basis is what it is worth when you received it.