With the catastrophic fall in investment values due to the coronavirus pandemic, many people are looking to raise cash wherever possible. A recent
Caution is required on selling art and other collectables not only because of the market, but also because the different treatment sellers of art receive under the Tax Code from sellers of other appreciated assets. Unlike gains from selling stock or bonds, which are taxed at 20 percent plus the 3.8 net investment tax, gains from the sale of art and other collectables are taxed at 28 percent plus the 3.8 percent net investment tax. Further, the code also treats you differently depending on your status as a taxpayer in relationship to the art.
At the same time, the CARES Act has increased the limits for deductions for charitable donations from 50 percent to 100 percent against adjusted gross income. This may seem like the perfect time to sell or donate art — but before they do so, taxpayers should consider the income taxation of selling, or donating, art.
Income taxation of selling or donating art
The Tax Code treats the sale of artwork differently based on the status of the taxpayer, whether they are the artist who created the work, a hobbyist, an investor, a business investor or a dealer.
1. Artists. The sale of artwork generates ordinary income to the artist, and the charitable deduction of artwork they created during their lifetime is limited to the costs of the materials used in creating the piece.
2. Hobbyists. A hobbyist is a collector who buys art without considering whether it will ever be a profitable investment. The hobbyist rarely sells a work, which if sold generally is a capital asset in which gains are recognized, but losses are not allowed (IRC Sections 1221 and 165(c), respectively). Expenses attributed to maintaining the collection are generally not deductible, per IRC Section 262.
3. Investors. An investor is a person who buys, sells and collects art solely as an investment, with the hope the asset will appreciate to enable sale at a profit. For an investor, generally the art investment when sold is taxable as a capital gain unless it falls outside the definition of capital asset. IRC Section 1221 defines capital asset to include all assets except:
- Stock in trade or property held by the taxpayer primarily for sale to customers in the ordinary course of their trade or business;
- Property used in a taxpayer's trade or business that is subject to the allowance for depreciation; or,
- An artistic composition held by the creator or a person in whose hands the basis of such artistic composition is determined by reference to the basis of the creator. A gift from an artist to anyone would fall under the third category and be taxable as ordinary income property.
A capital loss is available to an investor under IRC Section 165(c)(2), if the intent test of entering into the transaction for profit can be proved; the taxpayer must prove the purchase and the sale of the artwork was a transaction entered into for profit. Many factors are looked at based on the facts and circumstances of the taxpayer's case; however, the taxpayer's personal use and enjoyment of the artwork will generally be a critical factor showing the intent was not entered into for profit.
The expenses of the investments fall under IRC Section 212 with respect to deductibility, if an investor's primary intent was to hold the art for the production of income can be proved. This deduction is, since 2017, no longer available to art investors until 2025.
An investor can be classified as a dealer or a hobbyist instead of an investor based on the facts and circumstances in their case. Sometimes, investors want to be classified as dealers, when they have losses to be able to deduct the loss as ordinary income rather than as a capital loss.
4. Business collectors. A business collector does not buy the art for resale, but rather for purposes such as office display or decoration in the ordinary course of trade or business. As the useful life of art is not determinable, it is generally not subject to depreciation. In addition, many businesses buy art for investment that can place them in the category of investor or hobbyist. The art investment can be of such a nature that they cross the line into being a dealer. Again, facts and circumstances need to be reviewed in each individual case to determine the categorization of the activity.
5. Dealers. The dealer is one who buys and sells art as a trade or business. An art gallery is one of the types of dealers. Art dealers are taxed in the same way as any other retail operation. As such, all income including income from the sale of art is taxed as ordinary income (IRC Sections 61, 64). Expenses, if ordinary and necessary, are deductible under IRC Sections 162. Dealers sometimes want to be classified as investors because of the favorable capital gains rates, versus being taxed on said gains as ordinary income. Additionally, dealers including gallery owners often wear the hat of investor in art as well as dealer in art, keeping the two as separate activities. There are many court cases dealing with this issue, such as Williford v. Commissioner, T.C. Memo. 1992-450.
Charitable contributions of art
Caveat: When a taxpayer donates artwork to public charities, they have to include in their planning whether the charity wants the artwork or not. The same is true when lending art to a museum: The taxpayer does not get any income tax deduction, but the value of a piece that’s exhibited at a museum increases. The museum knows this, and often will not accept a loan without a commitment to donate the artwork in the future.
One of my clients collects ceramic, glass, metal, stone and three-dimensional artwork by contemporary artists. A loyal alumna of her alma mater, she has financially supported the college over the years. She planned on donating her whole collection to the college, so I suggested she ask the curator of the college to come and see her collection. The curator came, looked, and declined to accept any of the artwork she had collected. She did, however, express an interest in two mediaeval miniatures that my client had inherited. When asked why those two, the curator said that the college did not have artwork like that, and it would be difficult to find or purchase such pieces. As for the rest of the collection, they could acquire similar works, and had done so, for their collection.
So, remember that it is not the mission of a single college to preserve the taxpayer’s collection. Other institutions, such as local museums, might be interested and may not have them. It is worth doing some research to see which institutions might be interested in the different categories.
The computation of the amount of a charitable contribution, limitations that affect the amount of the allowable deduction and other aspects of charitable contribution are beyond the scope of this brief introduction. There are, however, issues involving charitable contributions of artwork that the private taxable collector should be aware of.
Donations by galleries, dealers and artists
The charitable contribution deduction for artwork by art galleries, dealers or the Artist who created the artwork is generally limited to the lesser of the fair market value on the date of contribution or the taxpayer’s adjusted basis in the artwork. In addition, an adjustment to cost of goods sold must be done to prevent a double deduction.
A charitable contribution deduction under IRC Section 170(a) is generally based upon the fair market value of the property at the time of the contribution (Treas. Reg. Section 1.170A-1(c)(1)). If a sale of donated property would have generated ordinary income or a short-term capital gain, the amount otherwise deductible is reduced by the amount of ordinary income or short-term capital gain that would have been recognized (IRC Section 170(e)(1)(A)).
Treas. Reg. Section 1.170A-4(b)(1) states: “The term ‘ordinary income property’ means property any portion of the gain on which would not have been long-term capital gain if the property had been sold by the donor at its fair market value at the time of its contribution to the charitable organization. Such term includes, for example, property held by the donor primarily for sale to customers in the ordinary course of his trade or business, a work of art created by the donor.”
IRC Section 1221(a)(3)(A) excludes from treatment as a capital asset certain property in the hands of the person who created it. For example, art created by an artist is ordinary income property in the artist's hands.
Donations by a hobbyist or investor
Generally, an investor is allowed a charitable contribution deduction for the donation of long-term capital gain property equal to the property's fair market value. Reductions and limitations to the allowable deduction may be required under IRC Section 170 under various situations. Treas. Reg. Section 1.170A-1(c)(2) states that “fair market value” is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Numerous issues have been litigated in this area over time.
Where artwork is donated to a charitable organization by an art gallery owner or a dealer in artwork, a potential tax issue is whether the artwork being donated is actually held as an investment or as inventory of the owner. The charitable contribution deduction for the long-term capital gain property is generally its fair market value, while the deduction for a contribution of inventory is limited to the lower of cost or fair market value.
The deduction for artwork that was gifted by the artist who created it to the investor, is generally limited to the smaller of the gift basis or the fair market value on the date of the charitable contribution. Under IRC Section 1221(a)(3)(C), the property retains its character of ordinary income property as it would to the artist who gave it. IRC Section 1015 states that the basis of property acquired by gift is determined by the basis in the hands of the donor (the artist). IRC Section 1221(a)(3)(C) excludes from being a capital asset property held by “a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B).” Subparagraph (A) describes “A taxpayer whose personal efforts created such property.”
Therefore, the amount of the charitable contribution deduction follows the rules discussed above under artwork donated by the artist, except the basis is the gift tax basis (artist basis adjusted for any gift tax under IRC Section 1015(d)). A taxpayer who donates art after obtaining the artwork by inheritance (regardless of whether it was part of the estate of the artist) is generally allowed a deduction for the fair market value of the artwork.
In the current low-interest-rate environment, the income tax deduction from the donation of artwork can be leveraged using split interest trusts, such as charitable remainder and charitable lead trust.
Conclusion
The relative insulation that the art market currently has from the declines in value that result from the pandemic may be a way to create that cash buffer needed to weather this storm. If so, taxpayers should consider the net after-tax return on the sale. Also, with the 100 percent deduction against adjusted gross income, they should consider offsetting the gains with a charitable donation or leverage the donation through a split interest trust.
