CGNA: Chapter 7 - Tangible Property, Advanced - Part 1 of 2

CGNA: Chapter 7 - Tangible Property, Advanced - Part 1 of 2

Article posted in General on 17 October 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 1 November 2018
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Summary

Tangible property is complex from a gifting perspective. Here we present thorough analysis of the important rules.

 

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

by Armen Vartian1

Below is an in-depth examination on gifts of tangible property. Tangible property topics are based on Armen Vartian’s “Charitable Donations of Art and Collectibles.” For quick take-aways on gifts of tangible property, see Tangible Property Quick Take-Aways. For a review based on that article, see Tangible Property Intermediate. For an in-depth examina- tion adapted and excerpted from the article, see Tangible Property Advanced. For further details, see Tangible Property Additional Resources.

Executive Summary

Tangible personal property includes works of art and collectible items such as jewelry, rare coins and stamps, and historical documents. Whether a specific gift of tangible personal property to a charity qualifies as tax deductible, and to what extent, will depend on:

  • How the donor holds the property (capital gain or ordinary income property)
  • The type of charity (publicly-supported or private)
  • Whether the charitable organization can put the property to use, and
  • Whether the gift is of present or future interest

Regardless of whether a donation of tangible property provides tax benefits in theory, realizing those benefits involves application of best practices in connection with appraising the values of the property being donated, as well as keeping proper records.

This is an extremely complicated area of law, changing slightly with every major revision of the tax code, and for three reasons art and collectibles are uniquely difficult assets to deal with in tax planning. First, because art and collectibles can increase greatly in value over time, taxpayers often search for ways to minimize the tax impact of such appreciation when they donate their collections. Second, because public policy deems the study and display of art and collectibles to be in the public interest, tax-exempt organizations such as museums and universities actively pursue donations of such items. Third, because the values of art and collectibles are so subjective, and may differ for different purposes, there is room for serious argument between taxpayers and the IRS.

Key Questions

While every taxpayer’s situation is different, there are some basic questions to ask when evaluating charitable donations of art or collectibles.

Is the Property Capital Gain Property?

The first question is whether the donor is giving long-term capital gain property. If so, the charitable donor may deduct the full fair market value of the property at the time of the gift, including market appreciation. If not, the donor can deduct only his actual cost basis in the property, which is generally the amount the donor paid for the property. The difference in tax treatment might make the prospective donor consider a testamentary donation rather than one inter vivos. A life-time gift removes the asset from the estate, and effective charitable estate tax deduction as well as provides a current deduction, even at cost basis, which would be lost through an estate gift.

The Internal Revenue Code defines capital gain property in this context as “any capital asset the sale of which at its fair market value at the time of the contribution would have resulted in gain which would have been long-term capital gain.”2 Generally speaking, art or collectibles which owners held over one year will be considered long- term capital gain property. A major exception, however, applies to items considered “inventory.” This includes items an art dealer owned as part of a trade or business. It also includes creators holding their own items, (i.e., artists holding the original works they created). Since the IRS considers an artist's own works “inventory” or “ordinary income property”, artists who donate their works to charity may deduct only the value of their “paint and canvas” incorporated into the work. This tax treatment also extends to persons who receive artworks as gifts from their creators. Finally, for collectors or investors who donate property they have held for less than one year, regulations usually limit the deduction to the price they paid for the property, because the IRS considers such property short-term capital gain property.

How Will the Charity Be Using the Donated Item?

The next question is the use to which the charity puts the donated items. Charities sometimes accept gifts for their own use as part of their regular activities, and in other cases charities sell gift items as part of their fund-raising. According to the Internal Revenue Code, donors may deduct items of tangible personal property which the charity puts to a use “not unrelated” to the charity's tax exempt purpose at their full fair market value, but not items which the charity uses for “unrelated” purposes. Here is the example given by the IRS in Publication 526, entitled “Charitable Deductions”:

“If a painting contributed to an educational institution is used by that organization for educational purposes by being placed in its library for display and study by art students, the use is not an unrelated use. But if the painting is sold and the proceeds are used by the organization for educational purposes, the use is an unrelated use.”3

The most common “unrelated use” in the art and collectibles field is the charity auction, where collectors donate items for charities to sell for their own benefit. The IRS's example demonstrates the peculiar nature of the “related-unrelated” distinction. A collector choosing between two organizations to which to donate a particular item might well find that one organization would put the item to a related use, while the other would not. If the item is one that has appreciated greatly over time, donating to the former charity might result in a much higher tax deduction.

Practitioners can learn from three Private Letter Rulings the IRS issued to taxpayers contemplating charitable donations of art and collectibles. In one case, the IRS found that a collection of porcelain given to a public charity operating a retirement home was “related” to the charity’s exempt purpose, namely creating a comfortable living environment for its residents.4 Likewise, in another case, the Service found that lithographs donated to a camp for disabled children was “related” to the charity’s exempt purpose when the camp used them in connection with an art appreciation program.5 But in a third case, the IRS found that a classic car donated to a university did not meet the “related use” test, because there was no indication that the organization used the car in connection with any academic program.6

Quite often, donors are not in a position to know how charities will use their gifts of property, and charities do not ordinarily know the donor's tax basis in donated prop- erty, or whether the donor held the property for more than a year prior to the donation. In other words, neither donor nor charity may be aware of whether or not the gift will result in the maximum tax benefits to the donor. Moreover, what happens when a charity displays a gift for a while in its library and then sells? The IRS allows donors who believed in good faith that the charity would use their gifts for “not unrelated” purposes to take their full fair market value deduction, even if the property is ultimately sold, but only if the charity holds the property for one year. Donors may also request a certification from the charity that the donated items will be put to a related use, and such certifications are often conditions precedent to donations.

If the charity sells a donated item within three years of acquiring it, however, the charity must file Form 8282 with the IRS giving the donor's name and the amount for which it sold the item. This enables the IRS to check the “fair market value” deduction the donor took against the actual value the charity received when it sold the item.

As with the analysis of whether regulations permit capital gain treatment, artists who donate their own works are limited to the items’ cost basis (paint and canvas).

Is the Charitable Organization a Public Charity or Private Charity?

Even if long-term capital gain property is put to a related use, the amount of the deduction can still vary. It depends upon whether the charity is publicly-supported or is a private foundation, and whether the taxpayer wishes to deduct full fair market

value in the current year or spread out (“carry over” in IRS parlance) the deduction over up to five years. Taxpayers may deduct gifts to public charities of up to 50 percent of the taxpayer's adjusted gross income in any given year, while donations to private charities are limited to 30 percent and, in some cases, to 20 percent.

A public tax-exempt organization is one that receives at least one-third of its support from the general public; museums, universities and other schools, hospitals and churches are among the institutions that generally qualify. A private tax-exempt organization does not rely on funding from the public. The Ford Foundation is one prominent example, and there are many private foundations which receive funding primarily from specific wealthy individuals.

For donors unsure which category a particular charity falls under, the IRS says to ask them: “You may ask any organization whether it is a 50 percent limit organization, and most will be able to tell you.” But gifts of capital gain property are limited to 30 percent regardless of the public recipient, unless the taxpayer elects to deduct only his or her basis, and not any appreciation. If the contributed property satisfies the related-use rule, the taxpayer may elect to increase the 30 percent limitation to 50 percent of his or her adjusted gross income. But if the taxpayer makes that election, the amount of the deduction must be reduced by 100 percent of the appreciation in value of the property. In other words, the IRS limits the deduction to the donor's cost basis.

For example, a collector has an adjusted gross income of $150,000. He contributes to a museum a long-term capital gain visual arts collection with a fair market value of $90,000, and a cost basis of $40,000. If the donor has a qualified appraisal prepared, he has made a gift of $90,000, of which $45,000 (30 percent of $150,000) is deductible in the year of the gift. But if that visual arts collection is donated to a charity but not related to the charitable purposes or functions of that charity, the collector's deduction will be the cost basis of $40,000. That cost basis amount is fully deductible under the 50 percent ceiling, with no carryover.

Is the Donation of a Fractional Interest Only?

Fractional donations of art were once a favorite means for donors working with charities to “have their cake and eat it too,” retaining physical possession of their art but obtaining tax benefits as well. But effective August 17, 2006 the rules changed. Donations after that date (with a small exception—see below), must comply with certain requirements that discourage the practice of fractional donations:

  • First, the donor or the donor and museum together must own 100 percent of the property immediately before the gift, and the donor must agree to donate the remainder ownership interest within ten years or the donor's death, whichever occurs first.
  • Second, the IRS limits the donor, after receiving a qualified appraisal, to a charitable deduction for the fair-market value of the initial fraction donated. He can also carry forward his deduction for five years, but can only deduct an amount up to 30 percent of his gross adjusted income in any given year.
  • Third, the subsequent fractions require new appraisals, and the donor may deduct only the lesser of the first appraisal or the current appraisal. In other words, if the value of the art has increased the donor receives no tax benefit, but a decrease in value decreases the tax benefit available to the donor.
  • Finally, the charity is legally obligated to take “significant physical possession” of the work and use it for a related use within the ten-year period.

If a donor has given a fraction before the effective date of August 17, 2006, that donor receives one subsequent fractional donation at then-current (possibly higher) fair market value. After that point, any additional donations are valued as the “lesser of” standard applicable after 2006.

  • 1. This chapter excerpts and adapts Armen R. Vartian, “Charitable Donations of Art and Collectibles” (2016) (on file with author). Thanks to Mr. Vartian for his assistance.
  • 2. IRC § 170(b)(1)(C)(iv)
  • 3. IRS Publication 526, “Charitable Contributions,” 12 (2015).
  • 4. Private Letter Ruling 8143029 (July 29, 1981).
  • 5. Private Letter Ruling 7751044 (September 22, 1977).
  • 6. Private Letter Ruling 8009027 (November 29, 1979).

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