Planning for Art and Collectibles
Viewpoints on Financial Planning
In 2012, Edvard Munch’s “The Scream” set a world record for the most expensive artwork ever sold at auction. The Munch painting sold at Sotheby’s for $120 million. Only a year later, on November 12, 2013, the record was easily surpassed by the sale of a 1969 painting by Francis Bacon, entitled “Three Studies of Lucian Freud.” After only six minutes of fierce bidding, the surreal work of art sold for over $142 million at Christie’s in Manhattan. On that same one evening, Christie’s sold over $691.5 million of art; the highest total for any single auction in history.
Art or collectibles (e.g. rare stamps, furniture, jewelry, coins, clocks, motor vehicles, wine and historic memorabilia) are a unique investment that can make up a sizeable portion of a person’s estate. The buyer’s physical possession of and psychological attachment to these one-of-a-kind objects cannot be compared to stocks, bonds or even real estate.
Conversely, art and collectibles:
- Are subject to a speculative and often fickle marketplace
- Have fair market values that are difficult to determine
- Can be expensive to insure from theft, defective title and other risks of loss or damage
While investor interest fluctuates depending upon the artist and type of work, the prices paid for highly prized and selected pieces have broken historical records.
Unfortunately, many professional advisors (and sometimes their clients) are inattentive to the specialized planning required for these valuable and cherished pieces. With detailed professional guidance and knowledge, however, collectibles can be a manageable, potentially profitable and personally rewarding investment.
FREQUENTLY ASKED QUESTIONS
1. What are some risks of investing in art and/or collectibles?
As the stock market and world economy becomes more unpredictable, investors worldwide seek out “safe havens” for their investment dollars. Today, many are looking to collectibles as an alternative to stocks, bonds and real estate. These assets may act as a hedge against a precipitous fall in the stock market, currency fluctuations or even skyrocketing inflation.
Despite their personal and investment benefits, some collectibles are susceptible to the “vagaries in fashion” of buyers. In a short period of time, market values may go down just as fast as they may have risen. For example, in 2010, “Fertility” by Edvard Munch, a $25 million field-couple scene, failed to sell at auction as interest in the artwork and the artist waned. Yet, only three years later, Munch’s “The Scream” broke worldwide auction records by selling for $120 million at Sotheby’s.
As volatile as the collectibles market may seem, the underlying asset value can oftentimes remain resilient in thorny economic times. In many cases, recessions have not dramatically impacted the overall sale prices of classic artwork and other collectibles because the number of buyers, as measured against the limited supply of prized pieces, has outweighed the number of sellers. For example, in 2006, the painting “The Battle between Carnival and Lent” sold for about $5.4 million at Christie’s. Only four years later, the same painting sold for $10.7 million—roughly doubling in value.
Of course, the costs and financial risk are not relevant to experienced collectors of rare items. The emotional and aesthetic pleasure the item gives them outweighs these apparent hazards. Clearly, the collectibles market is not for the faint of heart.
2. What is the meaning of “Fair Market Value” in the collectibles world?
As a general tax rule, transferred collectibles must be valued at fair market value (FMV) for federal income, estate and gift tax purposes. FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any pressure to buy or to sell and both having sound knowledge of the important facts. A number of factors may be taken into consideration, such as expert opinion, professional appraisals, purchase price of the collectible and sale prices of comparable items.
Surprisingly, the sales price may not provide the best evidence of FMV, even when a gift or other transfer occurs close in time to the collector’s original purchase. Instead, one may very well need to get a formal, independent appraisal of the collectible for transfer tax purposes.
FMV rules are particularly harsh for estate tax purposes. If a collectible is being valued based on the item’s auction sales price, the IRS requires the “buyer’s premium” to be investments added to its estate tax value. In auctions lingo, the “buyer’s premium” is a percentage additional charge on the winning bid (“hammer price”). This premium is paid by the buyer to cover auction house expenses. The buyer’s premium does not benefit the seller’s estate in the least, yet estate tax on the amount is paid by the seller’s estate.
For charitable gifts, FMV is also critical to determine the income tax deduction. Recently, the IRS has been giving increasing scrutiny around sizeable charitable deductions. They require a “complete description of the object, indicating the size, the subject matter, the medium, the name of the artist, [and] approximate date created.” Also, in the case of an audit, the IRS has an “Art Advisory Panel” that will review and evaluate appraisals submitted by taxpayers in support of the FMV claimed on both federal income as well as transfer tax returns. Having proper FMV documentation prepared by an expert appraiser specializing within the specific collectibles market attached to a federal (or state) tax return best mitigates potential IRS challenge and associated legal costs.
3. What are some estate planning techniques applicable to art and collectibles?
We typically associate the term “ownership” to mean full title and control of property. Contrary to this concept of ownership, group purchases are commonplace in the collectible market among museums, investors and aficionados. Long-term and short-term collectible investors often times want to preserve their cash for other investment opportunities so they seek to convince one or more investors to jointly purchase an expensive treasure.
In some cases, high-value collectibles may be owned as fractional interests where individuals own only part (or a fraction) of a single, high value collectible to reduce, or “compress”, the value for future transfer purposes. As the price of and interest in collectibles continues to rise, fractional transfers are becoming widespread. Fractional ownership is a complex tool and, not surprisingly, a controversial issue with the IRS. Put simply, an owner may deliberately use fractional interests to “compress” the value of a gift to family members. Courts have historically recognized two valuation concepts employed to “compress” the value of the artwork: “lack of marketability” and “lack of ownership control.” These two factors, when applied together, reduce the value of the collectible since a fractional interest is theoretically more difficult to sell and convert to cash in the marketplace.
For example, an owner of a $1,000,000 piece of artwork wants to gift the painting to his three daughters. The artwork may be placed in a very specialized legal entity that enables the owner to gift only a fraction of ownership to each daughter at a reduced value. Since each family member has only a partial ownership interest in the art, their individual interests may be reduced in value. Hence, this discount can result in decreased value of the actual gift. This concept has been used for decades to transfer valuable collections of art and other collectibles to family members.
Recently, a federal court denied discounts for collectibles owned jointly by family members. This decision is one of several cases, with similar results, issued by courts over the past decade due to poor execution of the plan. Therefore, careful and specialized planning is required before this tax benefit can be applied successfully to a collection of treasure items.
From an estate planning perspective, transferring collectibles out of the client’s estate is generally the main focus. By getting the appreciating asset out of the client’s name and into the younger generation, estate tax can be partially or completely avoided. Despite this, collectibles are not like high value brokerage accounts, business interests or vacation homes. Rather, a collector does not want to give it away or lose control. This presents a major problem since the application of estate tax is mainly determined by the facts of possession, title and control.
Furthermore, once a collectible is transferred to the next generation, these new owners (e.g. lineal descendants) have received a gift that is not only highly valued but also expensive (insurance, storage, etc.) to own. Because collectibles produce no income to cover these expenses, family members without the wherewithal to cover these expenses may be forced to part with these treasures.
As a substitute to gifting, some collectibles (especially expensive artwork) can be used as collateral for loans or possibly to generate rental income. A multitude of charitable planning options are also available, which may satisfy an owner’s desire to mitigate transfer taxes, receive an income tax deduction and/or fulfill a philanthropic dream.
4. What is the income tax consequences associated with the sale of collectibles?
A covered call is utilized when an investor holds a stock and writes (sells) a call option for a set period of time (expiration date) on the stock to generate increased cash flow from the position. The sale of the call option places a ceiling on the potential share appreciation; however, the upfront option premium received offsets some of this lost opportunity cost. A covered call provides the investor with an increase in immediate cash flow but the downside protection on share price is limited to the option premium received on the front-end of the transaction. Accordingly, it is not a strategy designed to protect against more significant market losses.
The income tax consequences on the sale of a collectible are dependent upon whether the seller is treated as a “collector”, an “investor” or a “dealer”. Each of these classifications has differing income tax rules associated with sales.
Upon sale, a “collector” is subject to capital gains taxes (maximum 28% federal rate, plus state taxes if any) if held for more than a year and day. According to the IRS, a “collector” merely trades collectibles as a hobby. The enjoyment of ownership is the main focus, rather than making a profit on sales. Since a “collector” does not purchase collectibles as inventory for a business, the taxpayer must pay state and local sales taxes. If a collectible is purchased with a loan, the interest is not deductible since it is deemed “consumer interest.” Deductions to offset that taxable income are negligible. There is one exception: In a charitable setting, a “collector” who donates an expensive, highly appreciated collectible will obtain the fair market value of the deduction to the charity where the collectible is related to the charity’s purpose.
The tax situation improves for an “investor”. According to the IRS, an “investor” is an individual who puts money into a business or other asset for the primary purpose of making profits. Qualifying for the “investor” status is not as simple as making a declaration. An “investor” should actively loan items to museums, obtain regular appraisals, have appropriate insurance, keep detailed business records and, generally, be motivated by profit rather than enjoyment of owning collectibles. On the other hand, an “investor” should not be actively involved in the business or store the inventory in their home. Unlike the “collector” or “dealer” category, “investors” may qualify for IRC §1031 like-kind exchange treatment to defer taxes on sale. To qualify for this treatment, the collectible must be exchanged for property of a similar asset class (e.g. stamp for stamp or painting for painting). Moreover, the exchanged property must be used in either a business or for investment purposes.
Finally, the “dealer” category applies to a taxpayer who engages in the full-time business of selling and procuring art. The taxpayer must prove the “dealer” status to the IRS. If all the transactions are purchases and not sales, the IRS may determine that the taxpayer is not a “dealer”, but is engaging in a hobby. To counter this argument, an individual should create a legal entity (i.e. LLC or corporation) to conduct transactions and hold inventory, have business cards and stationery, participate in trade group activities, remit sales taxes from purchases and advertise in industry-specific magazines. A “dealer” may deduct ordinary and necessary business expenses, unlike the other two categories. Lastly, a “dealer” can donate art only at cost, not the fair market value claimed by the “collector” category.
5. How can one protect themselves from fraud or theft in the collectibles marketplace?
Clear legal title is the hallmark of true property ownership. Collectibles, like any other type of tangible investment, can have titles cluttered by liens or other claims to ownership. Certainly, a buyer should ensure that the seller actually owns the property he or she is seeking to purchase. An unclear title can have severe consequences to the buyer, who may have to give the item back to the rightful owner.
Purchasing fine art or other high value collectible requires the same level of assurance and due diligence as real estate. Fraud, theft, money laundering, black-market sales, “Holocaust claims” or tax liens may all clutter the ownership and provenance of a collectible. Contested ownership is not an uncommon phenomenon as ownership claims are occurring around the globe more frequently than ever. Accordingly, title insurance may be a worthwhile expenditure to protect one’s expensive collection from future legal challenges. Property insurance is critical as well.
Collectibles such as art, rare stamps, furniture, jewelry, coins, wine or classic motor vehicles can make up an important and treasured part of a person’s estate. Their scarceness and splendor are a great testament to an owner’s status and ideals, yet also brings the owner emotional satisfaction.
Although these unique assets may be bought for personal and expressive reasons, the potential financial gain they might bring the owner cannot be denied. The short-term, profit-driven investor must be aware of the illiquidity, risks of loss, upkeep expense and other difficulties inherent in collectibles. Furthermore, the rare art and collectives marketplace is perilous, fickle and lacks transparency.
In spite of these risks, advice from an experienced professional team is important to successful collectible investing.