Many collectors view art as more than a financial investment and often do not wish to readily part with a piece of sentimental and aesthetic value. Nevertheless, when an art collection is part of a taxpayer’s estate a number of estate, gift and income tax strategies should be considered.
Prior to ATRA 2012 (American Taxpayer Relief Act of 2012), estate tax planning often involved gift and estate tax strategies designed to eliminate appreciating assets from an estate in order to reduce estate and gift taxes. After ATRA, the federal estate tax exemption has been made permanent at $5,000,000 (indexed for inflation) so fewer taxpayers are subject to federal estate tax. At the same time, federal income tax rates have increased, so income tax planning has become more relevant. Accordingly, it may be advantageous for taxpayers not subject to estate tax to leave appreciating assets in their estate to get a “stepped-up” basis at their death. This would reduce potential income tax on the gain when sold by the beneficiary or heir who received the asset.
An art collector should seek regular qualified appraisals of the collection, perhaps even annually, to get a better understanding of how the collection is appreciating. In the case of a gift or a charitable contribution, such application can help substantiate a work’s value if there is an IRS challenge, protecting a collector from additional taxes and penalties for undervaluation. Further, if a piece is worth more than $5,000, a taxpayer seeking a charitable income tax deduction will need to include a qualified appraisal with his or her tax return. Qualified appraisals may also be necessary when artwork is left as a bequest in a Will. For estate tax purposes, an appraisal must be included with the estate tax return for any piece worth more than $5,000 or for a collection of similar items worth more than $10,000. For gift tax purposes, a qualified written appraisal is typically the best way to disclose a gift of artwork on a gift tax return. It is important to check out the appraiser’s credentials to ensure that the appraiser is an expert in the type of item. A qualified appraiser who makes a false or fraudulent overstatement of value, may be subject to a civil penalty.
A taxpayer transferring an art collection containing at least one item valued at $50,000 or more may request an advance ruling from the IRS to ensure that the IRS will later accept the taxpayer’s valuation. An advance ruling may be requested only after the property is transferred and must include IRS Form 8283 (“Noncash Charitable Contributions”), along with a qualified appraisal, to make the request. An advance ruling costs $2,500 for the first three items and $250 for each additional piece.
An art collector who donates artwork to charity can also receive a substantial income or estate tax deduction. For instance, a taxpayer who donates to a public charity a painting purchased years ago for $1,000 that has a fair market value of $10,000 today and satisfies all tax criteria for deducting the donation will receive a $10,000 charitable deduction for income tax purposes. Donations may also help avoid capital gains taxes. This is helpful because while most assets are subject to a 15% capital gains tax rate (in 2013), art is subject to a higher rate of 28%.
A taxpayer donating art work should keep in mind that it is best for the donation to be related to the charitable organization’s charitable purpose. For example, donating a painting to be displayed at a tax-exempt art museum allows a taxpayer to deduct the painting’s fair market value, for up to 30% of the taxpayer’s adjusted gross income. If the amount deductible exceeds this limit, it can still be carried forward for up to five years. On the other hand, if the donated artwork is not related to the organization’s charitable purpose, the deduction is limited to the taxpayer’s cost basis, but up to 50% of the taxpayer’s adjusted gross income.
Another way to donate artwork to charity is to create a charitable remainder trust (CRT). This allows the trustee of the CRT to sell the art tax-free and reinvest the proceeds in income-producing assets. The beneficiary receives income from the trust, while the named charity receives what is left at the end of the trust term. It is important to note that since the donation is not related to the CRT’s tax-exempt purpose, the donor’s current income tax deduction is limited to the donor’s basis in the art, up to 50% of the donor’s adjusted gross income. Additionally, the donor’s current income tax deduction will be limited to the actuarial value of the charity’s remainder interest in the artwork.
For those art collectors who are not quite ready to part with a piece permanently by a donation of artwork to a museum, consider donating an undivided fractional interest in an artwork to a charitable organization instead. If a taxpayer donates a one-third (1/3) interest in a sculpture worth $5 million to a museum, the museum will have the right to display the sculpture for four (4) months out of each year. The benefit of a fractional donation is that the donor can enjoy the sculpture for the rest of the year, while still receiving a sizeable charitable income tax deduction. This is also a good alternative when an outright donation exceeds the donor’s adjusted gross income percentage limits. Donating a fractional interest reduces the amount of the income tax deduction, minimizing the need to worry about the five-year carry forward period, discussed above. A museum will usually be willing to agree to receive a fractional interest during a donor’s lifetime only if the donor agrees to donate the entire interest in the painting to the museum in the donor’s Will (or revocable trust). The donor’s estate would then be entitled to a charitable estate tax deduction for the donor’s remaining interest in the painting, based on the painting’s value at time of the donor’s death.
Before donating to charity in a Will, a collector should consider the unlimited marital deduction. The decedent can leave the artwork to his or her surviving spouse and then have the surviving spouse donate the artwork to the charitable organization during the surviving spouses’ lifetime. This gives the surviving spouse an income tax charitable deduction without a federal estate tax on the artwork in the estate of the deceased spouse because of the unlimited marital deduction. The advantage to this added step is that the surviving spouse will inherit the artwork at a new cost basis equal to the fair market value on the date of death of the first spouse. The surviving spouse can also bequeath the artwork in his or her own Will and receive a 100% estate tax charitable deduction. A taxpayer making a bequest of artwork to a charitable organization, through a Will should describe the artwork with as much specifics as possible. Additionally, since a charity can renounce a bequest, the Will should include an alternative beneficiary as well.
Finally, a collector may choose to keep the collection in the family and only leave artwork to heirs and other beneficiaries through specific bequests in his or her Will. Specific bequests can reduce conflict among family members and avoid some of the income tax issues connected with residual gifts. A taxpayer should discuss his or her plans with family members in order to avoid issues and surprises later on.
No matter how you choose to plan for your art collection’s future, you should consider the tips discussed above to gain the best possible return on your valuable investment.