Appreciation of fine art can create challenging tax issues, but with proper planning collectors can minimize the estate, gift, and income tax consequences of their collections.

For taxpayers hoping to keep their works in the family, a recent 5th Circuit Court of Appeals ruling provides some promising precedent for valuation issues. In Estate of Elkins v. C.I.R. [1], a deceased taxpayer had gathered an impressive collection of fine art with a fair market value (“FMV”) of roughly $35 million. Mr. Elkins and his wife, partially motivated by concerns about future estate tax liability, distributed fractional ownership shares in two groups of paintings to their three children. At the time of his death, Mr. Elkins retained a 50% interest in three works of art with a cumulative FMV of approximately $10.5 million and a 73% interest in a group of 61 pieces of artwork with a cumulative FMV of about $24.5 million. This division of ownership is a common tactic for passing assets to family members. The benefit lies in valuations for estate tax purposes, which may include large discounts from FMV to reflect the unenviable position of an unrelated prospective buyer owning a partial stake in a family asset with limited marketability. However, the IRS has seldom applied such discounts to partial ownership interests in pieces of fine art. In Elkins, the Commissioner argued that no discount at all could be permitted while the estate had calculated a discount of 44.75% for the entire collection. The Tax Court found neither argument appealing and instead applied a 10% discount across the board. The Elkins estate appealed the ruling and the 5th Circuit granted the estate a $14 million refund plus interest while applying discounts ranging from 50%-80% to the different ownership shares. The ruling provides some support for wealthy families considering fractional interests for their art collections. But complying with the letter of the law, which requires possession by each owner commensurate with their percentage interest, remains a challenge. In addition to discounted valuations, taxpayers with valuable collections can mitigate estate and gift tax consequences by removing value from their estate within the limits of annual and lifetime gift tax exclusions or by making gifts to an irrevocable trust with Crummey [2]withdrawal powers for the benefit of each of their children and grandchildren.

For taxpayers who want to bring their works of art to market, Section 1031 exchanges provide one avenue for tax relief. Section 1031 of the Internal Revenue Code offers a well-known exception to the rule that a taxpayer must report and pay tax on recognized gain when he or she sells or exchanges property. In a 1031 exchange, a taxpayer may exchange his or her property for other property of “like-kind” and then defer income tax on any gain that would otherwise be recognized. Subject to certain exceptions and timing rules, an exchange will qualify for a deferral of gain under Section 1031 if the taxpayer’s property is exchanged solely for property of like-kind and both the transferred property and the replacement property are held for productive use in a trade or business. [3] Section 1031 exchanges are most typically used for real estate swaps, but the 28% capital gains rate on collectibles and a bullish fine art market have rendered 1031 exchanges an increasingly popular option for art transfers. To take advantage of Section 1031, collectors must hold their pieces as investment property rather than for hobby or pleasure. This requires careful planning, including keeping detailed records, ordering regular appraisals and avoiding personal uses such as placing antique furniture in service at the taxpayer’s home.[4] Another obstacle is ensuring that the newly acquired artwork is considered “like-kind” property. There is minimal guidance on point, but professionals have derived from an IRS ruling under the more demanding standard of Section 1033 that oil paintings for oil paintings, sculptures for sculptures, or lithographs for lithographs are “similar” and “related in use” and should therefore be considered like-kind property.[5] With the limited guidance available, a conservative approach to 1031 exchanges for pieces of your collection is most prudent, preferably through a qualified intermediary familiar with art exchanges.