Friday December 13, 2019
Article of the Month
Investor or Dealer? - Gifts of Real Estate and Donor Classification
Philanthropically motivated individuals increasingly understand the value of gifting appreciated real estate to charity. Donors are often able to claim a deduction for the property's fair market value while also bypassing capital gains tax that would otherwise be due if the donor sold the property. This is a win-win solution for the donor from a charitable and financial standpoint.
What is the result, however, when a donor is classified as a "dealer" of real estate and decides to make a gift of real property to charity? In that case, the property is considered an ordinary asset and, as such, the donor's deduction will be limited to cost basis. On the other hand, if the donor is considered an investor, he or she will be able to claim a fair market value deduction for the gift.
The distinction between dealer and investor is an important factor that advisors must take into consideration when guiding clients through the charitable giving process. While some cases may be clear-cut, other times, the line may be blurry.
Part I of this article will shed light on this important distinction between real estate investors and dealers, provide factors that advisors should take into consideration when making this determination and offer case examples to illustrate each factor. Part II will use the factors presented in this article to examine some hypothetical examples where a client makes a gift of real estate to charity. Part II will also provide charitable solutions for donors who want to make gifts of dealer-classified property. By understanding how these factors are used to determine whether a property owner is a dealer or investor, advisors can help guide their clients toward a strategy that will maximize their tax benefits while simultaneously fulfilling the client's philanthropic goals.
A taxpayer who is a "dealer" of certain assets recognizes ordinary income rather than capital gain on the sale of those assets. Thus, the starting point for understanding the distinction between a dealer and investor is IRC Sec. 1221, which, in part, explains that property will not be considered a capital asset in the hands of a taxpayer if the property is "stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer 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."
Therefore, if an individual holds property for sale or as part of a trade or business, then he or she may be classified as a dealer. Alternatively, an individual who holds property for investment only is not a dealer, but is an investor. However, the line becomes blurred when determining at what point selling property changes from an "investment activity" to a "recurring business activity."
Again, this distinction is important because property held for investment purposes may be subject to more favorable capital gains tax treatment, while dealer property will be subject to less favorable ordinary income rates. While these categories are important for those buying and selling real estate, they also must be considered when an individual is planning to make a gift of real property to charity.
For example, if a donor is contributing real estate that has been held as investment property for many years, then the property is considered a capital asset in the hands of that donor and he or she will be entitled to a charitable income tax deduction equal to the property's fair market value. Capital assets include real estate that has been operated as a rental property or has been held as a management-free investment. If, on the other hand, the donor is in the business of flipping houses or developing real estate, then the real estate could potentially be classified as ordinary income in the hands of the donor. If the donor contributes this "dealer-type" property to charity, then the deduction will be limited to the donor's cost basis in the real estate. It is important to note that this status determination is made on a property-by-property basis, meaning that an individual could be classified as a dealer in the context of one property and an investor in the context of another.
The tax code and regulations do not provide clear guidance in making the dealer-investor determination. In fact, the Tax Court noted that there is an "indistinct line of demarcation between investment and dealership." Buono v. Commissioner, 74 T.C. 187 (1980). However, this classification issue has been litigated many times over the years and as such, advisors typically turn to case law when making this determination. There are five main factors that courts consider when classifying an individual as an investor or a dealer. The remainder of this article will examine each factor and provide case examples for further guidance. Advisors should consider all facts and circumstances in light of these five factors to ensure that they are providing their clients with accurate information and steering them toward a charitable gift that will maximize their tax savings.
THE DEALER-INVESTOR FACTORS
1. Frequency, Number and Continuity of SalesThe first factor, and perhaps one of the most important to consider, is whether the property owner has been frequently and continuously selling real property (see Biedenharn Realty Co., Inc. v Comr., 526 F.2d 409 (5th Cir. 1976) noting that the "the frequency and substantiality of taxpayer's sales" is the most important factor that must be considered). In Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court explained, "Frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment."
The more regular and continuous the sales, the more likely it is that the donor will be considered a dealer. Thus, when analyzing this factor, advisors should consider the following questions: How many properties has the donor sold? What was the time frame of these sales? Were the donor's sale activities regular and sustained or intermittent and occasional?
For example, in Hancock v. Commissioner, T.C. Memo 1999-336 (1999), the Tax Court held that the property owner's sale of 47 unimproved lots over a nine-year period demonstrated "frequent, regular and substantial" sales. In contrast, in Buono v. Commissioner, 74 T.C. Memo 187 (1980), the Tax Court found that, despite the property owner's intent to zone and subdivide a particular piece of property, the property was not deemed "dealer property" when it was sold. The Tax Court emphasized the "isolated nature of the transaction" and noted that it considered the "lack of frequent sales to be the most important objective factor for purposes of characterizing the gain petitioners received." The fact that it was a single sale precluded a finding that the property owner "was engaged in substantial and frequent real estate sales over an extended period of time."
While, in many circumstances, the courts have found that a single sale will not result in dealer status, there have been cases where a property owner was classified as a dealer on the first transaction (see Allen v. US, 113 AFTR 2d 2014-2262, (DC CA) below). As such, all factors must be considered even if the donor has not engaged in frequent and continuous sales in the past.
Trouble often arises where the donor has engaged in more than a single sale but fewer than what would clearly be considered a substantial number. When the status of the property owner falls into this "gray area," the courts will dive deeper into the other factors to make an ultimate determination. If a client who is considering making a gift of real estate to charity falls into this area, the advisor should look to case law and carefully analyze the remaining four factors to determine whether the scales tip more toward classification as an investor or a donor.
2. Nature and Purpose of Holding or Purchasing the PropertyThe second factor focuses on the intent of the property owner. Here, the questions are: What was the donor's original purpose when acquiring the property and what was his or her intent at the time the property was transferred? Was the property purchased with the intent to hold it as an investment or was it purchased for the purpose of development and sale?
In Allen v. US, 113 AFTR 2d 2014-2262 (DC CA), a district court in California shocked many advisors who had long believed that a single transaction would not result in dealer status. In Allen, the court held that the one-time sale of land would be subject to ordinary income tax treatment. While the first factor the frequency, number and continuity of sales weighed in favor of the property owner, the court noted that the evidence clearly demonstrated that the property owner purchased the land with the intent to develop and sell it. This intent was further demonstrated by the property owner's efforts to sell the property. Ultimately, the court found that the property owner purchased and held the property with the intent to develop and sell it in the ordinary course of his trade or business.
It is important to note that the courts have recognized that intent can change over time. The most important intent to consider is that of the property owner at the time of transfer. For example, in Maddux Construction Co. v. Commissioner, 54 T.C. 1278 (1970), the property owner originally acquired a tract of land with the intent to subdivide it and construct homes. However, the Tax Court found that at the time the property was sold, the property owner had abandoned the "intention to subdivide the property for residential purposes and decided to hold the property for investment purposes, either as rental property or for eventual sale at a profit." The court noted that "intent is subject to change, and the determining factor is the purpose for which the property is held at the time of sale." Ultimately, the Tax Court found that while the property owner originally purchased the property to sell to customers in the ordinary course of business, this intent was abandoned and, at the time of sale, the property was held as an investment. As such, the property owner was entitled to report the gain as long-term capital gain.
Advisors should take intent into consideration when a donor is considering making a gift of appreciated real estate to a charitable organization. In order to ensure the donor receives a fair market value deduction, advisors should assist by analyzing the facts and circumstances to determine the intent of the donor with regard to the property in question at the time of the charitable transfer.
3. Nature and Extent of Taxpayer's BusinessThe third factor looks to the property owner's undertakings. Was the property owner actively engaged in managing, improving or developing the property? Activities like subdividing, grading, zoning and installing roads and utilities tend to favor dealer status rather than investor when analyzing this factor.
For example, in Pool v. Commissioner, T.C. Memo 2014-3 (2014), the Tax Court found that the property owner's act of developing a water and wastewater system was "more akin to a real estate developer's involvement in a development project than to an investor's increasing the value of his holdings." As such, this factor supported the Tax Court's ultimate holding that the property was not held for investment but was held primarily for sale in the ordinary course of the property owner's trade or business.
Again, it is important to note that this factor is analyzed in relation to the particular property involved. Thus, a property owner could be developing a residential neighborhood and be classified as a dealer for that particular tract of land and, at the same time, be holding a separate parcel of land for investment purposes. For example, in Pritchett v. Commissioner, 63 T.C. 149 (1974) the Tax Court granted investor status to a property owner who had historically held land for development and reported gain on properties he sold as ordinary income. The Tax Court found that the property owner had not made any effort to improve, subdivide or sell the property. Rather, he held it passively until he received an unsolicited offer to purchase the property. As such, the Tax Court held that the property owner was an investor in respect to this particular parcel. Therefore, the gain from the sale of the land would receive capital gain treatment.
Given the property-specific nature of this analysis, it is important that advisors analyze their clients' actions toward the property they intend to donate. If, prior to making a gift to charity, the client had been developing the particular property, a court may find that this factor supports classifying the client as a dealer, in which case the donor would have to limit the deduction to the property's basis. Advisors should consider all facts and circumstances involved and keep in mind that this factor is weighed in relation to the other factors involved. The greater the amount of development activity, the more likely that this factor will support a dealer-status finding.
4. Advertising, Solicitation and Sales ActivitiesThe fourth factor considers the property owner's sales and marketing involvement with regard to the property. Here, questions to consider include: At the time of the transfer (either sale or charitable donation), was the property owner spending a great deal of time and effort attempting to sell the property? Was he or she personally trying to find buyers? Was he or she involved in negotiating sales? How engaged has the property owner been in marketing, advertising and solicitation?
The more time the property owner has spent either personally advertising the property or working with sales agents, brokers or marketing professionals, the more likely it is that the court will find an underlying business, rather than investment, motivation. In Biedenharn Realty Co., 526 F.2d 409 (5th Cir., 1976), the court pointed to a property owner's sales efforts as evidence of dealer-like real estate activities. The court explained that the property owner "hired brokers who, using media and on site advertising, worked vigorously on taxpayer's behalf." The court made clear that hiring real estate professionals does not protect a property owner from dealer treatment, noting, "We do not believe that the employment of brokers should shield plaintiff from ordinary income treatment."
The less time and effort the property owner has spent on attracting buyers, the more likely he or she is to receive more favorable investor treatment. For example, in Byram v. United States, 705 F.2d 1418 (5th Cir. 1983), the court found that a property owner who sold 22 parcels of real estate over the course of three years should be classified as an investor, despite the large number of sales in a short period of time. The court noted that the property owner "made no personal effort to initiate the sales; buyers came to him. He did not advertise, he did not have a sales office, nor did he enlist the aid of brokers." As such, despite the number of sales, the court found that the fourth factor, among others, weighed in the property owner's favor and that the properties were held for investment and not for sale in the ordinary course of his trade or business.
Advisors should consider the amount of time that a client has devoted to sale activities and actively participated in the sales process prior to making a charitable transfer in order to avoid dealer status and claim a full fair market value deduction. As the Biedenharn case explains, the use of brokers and third party sales agents does not shield a property owner from dealer status. Advisors should look at all the facts and circumstances involved when weighing this factor and understand that owning a sales office, working with brokers to find a buyer and using media and signage to advertise are activities that may add weight to the dealer side of the scale.
5. Extent and Substantiality of TransactionsThe fifth factor looks at the overall level of the property owner's real estate activities. Questions to analyze here include: Is the property owner in the business of buying, selling, developing and improving real estate? If so, is it the property owner's full-time occupation? If the property owner is involved in multiple income-producing activities, what percentage of his or her income is derived from real estate activities?
While a property owner can be in the real estate business and still hold property for investment purposes (see Pritchett v. Commissioner, 63 T.C. 149 (1974) above), courts do consider the property owner's history with respect to his or her real estate transactions. In Galena Oaks Corp. v. Scofield, 218 F.2d 217, 220 (5th Cir. 1954) the court explained, "Congress intended to alleviate the burden on a taxpayer whose property has increased in value over a long period of time. When, however, such a taxpayer endeavors still further to increase his profits by engaging in a business separable from his investment, it is not unfair that his gain should be taxed as ordinary income."
When considering this factor, courts also look at the amount of income the property owner derives from his or her personal real estate activities in comparison to other income-producing activities. In Evans v. Commissioner, T.C. Memo 2016-7 (2016), the Tax Court found that even though the property owner, Jeffrey Evans, was employed by a real estate development firm, his personal real estate activities did not rise to the level of a trade or business. When classifying Evans as an investor, the court noted that Evans' "primary source of income was his full-time job" and that "any income he may have earned from developing properties accounted for an insubstantial portion of his income."
In contrast, in Gamble v. Commissioner, 242 F.2d 586 (5th Cir. 1957), the property owner, Harry Gamble, sold 70 parcels of land in a two-year period. During that time, Gamble was actively practicing law and earning money as an attorney and a notary. Gamble argued that since he did not have a license to sell real estate and because his legal practice was his only place of business, he was not in the real estate business. The court rejected his argument and classified him as a dealer with respect to the properties in question. The court explained that "a person may be engaged in more than one business" and that it was "significant that the petitioner's profits from his real estate ventures exceeded, during each of the two years in question, his earnings as a lawyer and notary."
Advisors who assist clients with charitable gifts of real estate should consider each client's current property dealings and past real estate transactions in addition to occupation, keeping in mind that even if a client's primary occupation is unrelated to real estate, it will not automatically prevent the client from being classified as a dealer. While a client can be in the business of buying, selling, developing and improving real estate and still hold property separately as an investor, the advisor will need to be prepared to present evidence that supports classifying the client as an investor with regard to the gifted property.
The classification of a donor as a dealer or an investor is an important, yet difficult, distinction that must be made in order to accurately report a charitable deduction where the property is gifted to charity. The process of making this determination, however, is not black and white. In Byram v. United States, 705 F.2d 1418, 1419 (5th Cir. 1983), the Fifth Circuit noted the difficulty and uncertainty that exists when it comes to this classification process, stating "[I]n that field of the lawreal property tenurewhere the stability of rule and precedent has been exalted above all others, it seems ironic that one of its attributes, the tax incident upon disposition of such property, should be one of the most uncertain in the entire field of litigation. But so it is..."
And so it is that advisors are faced with the task of guiding their clients through the somewhat murky waters that exist in the dealer-investor determination process. While there is no bright line, advisors can turn to the factors the courts have presented and the cases in which they are discussed. By understanding these factors and considering how courts have ruled in past cases, advisors can help guide their clients and determine the best charitable giving strategy, given the client's likely status as a dealer or investor.