Friday March 29, 2024

4.5.5 Investor or Dealer

Investor or Dealer

Investor vs. Dealer Distinction:  Generally, assets used in a "trade or business" are ordinary and therefore deductible at cost basis when contributed to charity.

Who is a Dealer?  There is no "bright line" test to determine whether a particular taxpayer is a dealer.

The Charitable Deduction:  While long term capital gain property is deductible at fair market value when given to charity, contributions of ordinary income property are deductible only to the extent of the donor's cost basis.

Investor vs. Dealer Distinction


Generally, assets used in a "trade or business" are ordinary and therefore deductible at cost basis when contributed to charity. Even if a donor does not conduct a trade or business, however, the deduction may be limited to cost basis if he or she acts like a business owner with regard to the contributed property. This is because the IRS classifies a donor who acts like a business owner with regard to the contributed property as a "dealer" rather than as an "investor."

A taxpayer who is a "dealer" of certain assets recognizes ordinary income rather than capital gain on the sale of those assets. This is because property held by a dealer is ordinary rather than capital gain property. Such ordinary property held by a dealer is "stock in trade of the [donor] or other property of a kind which would properly be included in the inventory of the [donor] on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." Sec. 1221(a).

Who is a Dealer?


There is no "bright line" test to determine whether a particular taxpayer is a dealer. It is clear that a taxpayer who owns property for investment only is not a dealer. Uncertainty arises in trying to determine at what point selling property changes from an "investment activity" to a "recurring business activity."

The important facts and circumstances considered when determining whether a donor is a dealer include the frequency and continuity of his or her sales, efforts to initiate sales, presence of a sales office, nature of improvements or other development activity with respect to the property and intention of the donor when property was purchased. It is possible for a donor to start out as an investor, but through his or her activities become a dealer. Rev. Rul. 79-256.

If a donor is unsure whether his or her activities are as an investor or dealer it is very important for him or her to seek competent counsel prior to making the gift.

The Charitable Deduction


While long term capital gain property is deductible at fair market value when given to charity, contributions of ordinary income property are deductible only to the extent of the donor's cost basis. As a result, when a dealer contributes property, he or she is able to deduct only the cost basis of that property because, in the hands of a dealer, the asset is ordinary. As always, if a donor is an investor rather than a dealer, he or she will be able to deduct the full fair market value of the donated asset so long as it is a long term capital asset.

Example 4.5.5A

Fanny Flower's favorite hobby is gardening. Fanny likes to utilize her hobby to bring joy to others, so every year she grows lots of roses and donates them to all the local hospitals for Valentine's Day. Fanny would like to receive a charitable deduction for the gift of her flowers.

Because Fanny is making the gift on Valentine's Day, the roses have a fair market value of $100 a dozen and a cost to Fanny of $12.50 a dozen. Does Fanny get to take a deduction for the fair market value of $100 per dozen?

Normally, gifts of tangible personal property that have a use related to the charity's exempt purpose are allowed a deduction at fair market value. However, if the gift is inventory or an ordinary income asset, the deduction is limited to the donor's cost basis. Fanny does not operate a flower business and has been growing the flowers for over a year, which is one of the requisites for the flowers to be considered a long-term capital gain asset. Thus, it would seem that Fanny's gift would qualify for a fair market value deduction.

Because Fanny grows the flowers and contributes them yearly, she is acting like a flower grower and therefore would likely be considered to be in the business of growing and selling flowers. What is important here is whether Fanny's actions resemble those of a flower grower. Based on the facts given, Fanny's actions are identical to those of a flower grower. Thus, even though she does not sell the flowers, her actions are enough for her to be considered a dealer. Fanny's deduction will be limited to her cost basis of $12.50 per dozen.

Example 4.5.5B

Fred Flannery, 56, purchased a large piece of real estate last year for $500,000. Fred purchased the property intending to subdivide it into 100 lots and immediately sell the lots for a huge profit.

After selling over 50 of the lots Fred learns about charitable remainder trusts (CRTs) and would like to use some of the lots to fund a CRT. Fred could really use the tax deduction from the CRT to offset income from the sale of his lots.

The lots are worth $25,000 each and Fred will fund the trust with five lots. Fred will likely be considered a dealer of lots, given the facts. Therefore, if he creates a CRT his deduction will be calculated on his basis in the lots rather than the lots' fair market value.

If Fred funds the CRT with five lots, the funding amount would be $125,000, the fair market value of the lots. His deduction, though, is calculated on his cost basis of $25,000 ($5,000 x 5). Fred's deduction for the CRT would be $8,757. If Fred had not been a dealer his deduction would have been $43,784.

Fred's payout from the CRT is still determined based on the fair market value of the property. Thus, with a 5% payout Fred will receive $6,250 in the first year.

Even though Fred's deduction is reduced, he does not have to report the sale of the lots in the CRT as part of his income and his payout from the trust is still based on fair market value.

Case Studies on Investor or Dealer

Developer Doubles Unitrusts:   Donald Developer was a creative and entrepreneurial person. His business and personal affairs often made newspaper headlines. Through a stormy and turbulent career, he acquired large parcels of property and developed them with either commercial buildings or residential structures.


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