Donating art in order to obtain a tax deduction can be complicated — but it might very well be worth the effort. Consider these more advanced strategies for donating your art. With these methods, you can use your art collection to leave a philanthropic legacy — and benefit from a tax deduction at the same time.
Sell it at a Bargain Price
In a bargain sale, you sell a work of art to a charity at a substantially reduced price. Bargain sales offer the opportunity to partially monetize the value of the artwork you own, along with producing an immediate charitable income tax deduction. Because the artwork is offered to the charity at a greatly reduced price, the transfer is considered part sale and part gift; the discounted portion is the gift portion. But a two-part transfer makes determining the proper tax deduction a bit complicated.
For example, you might sell a work of art that you have owned for longer than 12 months (making it long-term capital gains property) to a favorite museum for $400,000. Say your adjusted tax basis in the art is $200,000, and the current fair market value of the work is $1 million. The gift element of the transfer allows you to obtain a tax deduction. If the fair market value of the art is $1 million, but you're going to receive $400,000 in the sale, the charitable gift component of the transfer would be $600,000 ($1 million less $400,000). Accordingly, you could claim a charitable deduction of $600,000.
The sale element is trickier. To calculate the taxable gain of the transaction, you must reduce the tax basis to reflect the $400,000 that was received in the sale. The reduction in tax basis is accomplished by multiplying the tax basis by a fraction: the sale price divided by the fair market value equals $80,000 ($400,000, divided by $1 million, multiplied by $200,000). To determine the long-term capital gains, take the amount realized ($400,000) and subtract your reduced tax basis ($80,000). The resulting $320,000 is subject to the current tax rate on collectibles. In addition, some or all of the gain would be subject to the 3.8% surtax enacted by the 2010 health care legislation. Most charities are familiar with this technique and are willing to explore such purchases.
Fund a Trust with Art
Collectors and tax planners often discuss the idea of funding a charitable remainder trust (CRT) with art. In such a scenario, you allow the trustee of the tax-exempt CRT to sell the art and invest the gross proceeds in a diversified portfolio of stocks and bonds. This portfolio can pay you an income stream for a term of up to 20 years or for the rest of your life. As the donor, you also receive a charitable deduction based upon age, current interest rates and actuarial assumptions by the IRS.
The plan sounds too good to be true: You receive a charitable deduction, an income stream for life and your charity gets the portfolio upon your death. However, it's not quite so simple. Remember that the donated property must be used to perpetuate the charity's charter. Selling the donated property and managing the proceeds is never considered a use that is related to the charter. Because the donation is not used to perpetuate the charity's charter, your deduction will be limited to your tax basis. If your main goal is to achieve a big charitable deduction, this is probably not the transaction for you.
Another problem often overlooked is the timing of the deduction. With a CRT, you only receive a tax deduction in the year the CRT trustee sells the art, not in the year that the art is contributed to the CRT. It is quite possible to contribute art to a CRT at the end of the year and have the trustee sell the art at the beginning of the next year. Under this scenario, you would have to wait until year two to claim a charitable deduction. If the timing of the deduction is crucial to you, begin this transaction as early in the year as possible.
Gift Fractional Interests in Art
For many years, art collectors relied on tax deductions achieved from gifting undivided fractional interests in art to charities. For instance, you might allow a museum to possess and display a piece of art for two months out of the year, while retaining the right to hold and enjoy the art for the remaining 10 months. This would result in a gift of a one-sixth interest in the art to the museum. However, in the past, donors could claim an income tax deduction for the value of one-sixth of the art even if the charity never actually displayed or took possession of the piece; it was sufficient for the charity to have the legal right to use it. But this option was widely abused.
The Pension Protection Act of 2006 significantly curtailed this practice. Today, fractional interests of tangible personal property are subject to complicated new rules. The charity now must take “substantial physical possession" of the property immediately, and use it for a charitable purpose. After the initial gift, the charity must receive the balance of the property, either 10 years after the donation or upon the donor's death — whichever comes first. In addition, donors' tax deductions for subsequent gifts are limited to either the market value at the time of the original fractional gift or the market value at the date of the subsequent gift — whichever is lower.
Additionally, the Technical Corrections Act of 2007 established that the estate tax charitable deduction for a fractional gift of art is equal to the market value of the fractional interest of art given to the charity at death. As a result of these new rules, gifting fractional interests in appreciating works of art is, for many collectors, no longer a worthwhile tax strategy.
Leaving a Legacy with Smart Planning
These strategies may seem complex, but the rewards, both personal and financial, can be significant. Your artwork can be used to both support a long-term, philanthropic legacy and obtain real tax savings for you and your family in the here and now. Though the rules and regulations around how and when you can do so are quirky, an experienced advisor can help you navigate them and ensure that your art is used to its full potential.