The Art of the Deal: Tax Consequences of Collecting

By Ginger Broderick

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Collector. According to the IRS, a collector buys art as a hobby. Thus, an art asset is not for the purpose of making a profit on sales, but primarily for the enjoyment of ownership. The collector does not purchase art for resale, and therefore pays state and local sales taxes. A collector who borrows money to purchase a work of art cannot deduct the interest, because it is classified as consumer interest. The only benefit of collector status is that the collection is considered a capital asset rather than inventory.

When a collector donates art to a museum, the fair market value of the deduction is identified as a charitable donation and he files IRS Form 8283, Noncash Charitable Contributions, with his personal tax return. This can be reversed under audit, however, if the IRS learns that the collector purchased and donated multiple copies of the same artwork. The taxpayer would then be classified as a dealer, and the deduction would be limited to the cost of the artwork.

A collector usually donates an item that has appreciated substantially in value. A common mistake is to accept a gift from the artist who created the work. In this case, the valuation is limited to the artist’s cost of materials, and there is no consideration on the holding period or the appreciated value of work. It is best to buy a work from the artist and pay by check or obtain a dated receipt for any cash purchases. The sale from an artist to a collector, regardless of price, avoids the basis limitation of the artist’s cost of materials.

Dealer. A dealer engages in the business of selling art. A taxpayer has the burden of proving she is a dealer in order to deduct ordinary and necessary business expenses. Problems can arise if dealer status is claimed by a part-time dealer who has other sources of business income, in which case the IRS could argue that the activity is only a hobby. Most private art dealers are full-time, because closing a single transaction may take weeks, months, or even years.

Proving dealer status is difficult if all transactions are purchases. Showing sales with appropriate gross profit percentages is important, even if fixed costs and other operational expenses create a loss on the financial statements. To help prove dealer status, the individual can create a corporation, establish a bank account, use business cards and office stationery, participate in trade groups, and advertise in industry magazines. A bona fide dealer obtains a sales-tax resale certificate and remits sales tax collected from customers. A dealer can donate art only at cost, not the fair market value claimed by a collector.

Investor. An investor is an individual who puts money into a business, real estate transaction, or other asset for the primary purpose of producing income or profits. Establishing this status for tax purposes is difficult because an art investor obtains the benefits of both being a collector and being a dealer. (See the Exhibit.) An investor should have a more passive interest in the work itself, and be primarily interested in the profit associated with selling the art, rather than the enjoyment of a collector. Most of an investor’s art is stored in locations other than his home, or is on loan to museums. An investor may well enjoy art, but must be willing to sell a work once it has appreciated in value.

For some advice on how to start collecting artwork and learn more about appreciating art, see the Sidebar.

Tax Benefits

A significant concern for anyone who owns art is qualifying for the lower long-term capital gains tax on the sale of a work. Collectors and investors are allowed the favorable tax treatment upon holding the work for the proper period. Dealers and artists are required to report the gain as ordinary income, regardless of any holding period.

The situation becomes more complicated when a dealer wants dual status as an investor. If art is purchased at auction, then sales tax should be paid and all accounting should be maintained in a separate corporation and bank account. In good tax planning, a dual-status dealer/investor will establish separate insurance policies, storage facilities, and two different accounts at an auction house as well. Segregating these activities in efforts to prove the fair market valuation taken on art donated to a charitable organization is important. The status of a donee organization should be verified by reviewing a recent edition of IRS Publication 78, Cumulative List of Tax-Exempt Organizations, or obtaining a letter from the IRS validating the donee’s status.

Appraisals for Charitable Gifts

A taxpayer who donates an item or a group of similar items (e.g., photographs, rare books, paintings) with fair market value of more than $5,000 must obtain a qualified appraisal not more than 60 days prior to the donation date in order to claim a deduction. The appraisal summary must be signed and dated by the appraiser, and be included in the tax return.

An appraisal report includes a complete description of the work; the name of the artist; the approximate date created; the cost and purchase date; a history of the item; its physical condition; photographs of the artwork; the expected date of contribution; the terms of any agreement for the donation; the name, taxpayer identification, and qualifications of the appraiser; the date of appraisal; and the work’s fair market value, along with the valuation method used (such as the income approach, the comparable-sales or market-data approach, or the replacement-cost-less-depreciation approach). The report should also include a statement indicating that the appraisal was prepared for income or estate tax purposes, and a description of the fee arrangement between the donor and the appraiser. Failure to provide this documentation within the tax return will lead to the disallowance of the charitable deduction.

Appraisals are recommended for art collections prior to acquisition, selling, insuring, making a gift, filing an insurance claim, claiming a casualty loss, or computing estate tax. Art appraisal is subjective, especially when valuing a unique piece. A qualified appraiser must perform appraisals on a regular and independent basis. Anyone who intentionally falsifies an appraisal summary is subject to civil penalties ranging from $1,000 to $10,000, and the appraisal may be
disregarded.

Advance Determination for the Value of Charitable Gifts

The IRS may accept the valuation or choose to make its own determination of the fair market value. It may hire an independent dealer or scholar when the art may require an expert appraiser with specialized skills, experience, and knowledge. The IRS normally does not review or approve any valuations prior to the actual filing of the return; however, the taxpayer may request an advance determination procedure from the IRS if an artwork has been appraised at more than $50,000.

The request can be made only after the donation has been made, and the application must be made early in the tax year so that the approval is obtained prior to preparation and filing of the return. The application fee is approximately $2,500 for the first three items and $250 for each additional item.

IRS Art Advisory Panel

The Art Advisory Panel is a group of 25 outside professionals hired by the IRS to evaluate and challenge taxpayer valuations of artwork in the $20,000-plus category. Panel members are prominent dealers, museum directors, and curators. They discuss each work and provide a conclusive fair market value of an item. The taxpayer’s identity is not disclosed to a panelist, but a prominent artwork is often identifiable as being from a particular collection.

A panelist who has a conflict of interest on any level of a particular matter must excuse himself from the conversations. Panel meetings are closed to the public, but a summary report is issued each year.