The red-hot art market has been the subject of newspaper headlines all over the world. Fueled by a growing worldwide demand and, in relative terms, fixed supply, prices continue to soar at record pace. Even yet-to-become-famous contemporary artists are selling their work at never-before seen prices. Sotheby's and Christie's have estimated February 2007 profits of approximately $400 million. Art collecting has reached fever pitch and wealthy estates have become increasingly concentrated in artwork.

All this begs the question: Once art is a part of the estate, what next?

For years, tax planners have suggested that clients use their highly appreciated artwork as the foundation for their charitable giving. A gift of artwork to a favorite museum or gallery could yield an income tax deduction for the full fair market value of the donated piece, build a special donor relationship with the institution and fulfill a client's philanthropic goals. A gift of highly appreciated art to a charitable remainder trust could have the dual benefits of a charitable income tax deduction and tax deferral on substantial capital gains recognized on sale.

One planning technique that became quite popular was the gift of an undivided fractional interest in artwork. Donors could transfer this interest to a 501(c)(3)- qualified museum and obtain an income tax charitable deduction equal to the fair market value of the fraction- al interest transferred. If the fair market value of an artwork steadily appreciated it naturally followed that the value of an undivided fractional interest in that art- work also would increase, so successive gifts of fractional interests of the same piece of art over several years could result in significant tax deductions for the donor. In addition, the art could be shared, spending a certain amount of time at the museum and the rest of the year on the donor's living room wall.

Apparently, Congress thought it was too good to be true. Despite the cries of museum lobbyists, lawmakers perceived fractional interest gifts to be a tax loophole for the rich and changed the law under the Pension Protection Act of 2006 (PPA). As a result, the tax code now provides that the fair market value of tangible personal property, of which a fractional interest is being transferred to a charitable donee, is fixed at the time the initial gift is made. The value of the fractional interest now is determined by using the lesser of (1) the property's fair market value as of the date of the initial gift, or (2) the property's fair market value as of the date of the additional gift. Future appreciation of the property cannot be taken into account. These rules apply for estate and gift tax charitable deduction purposes as well.

Assume that in the summer of 2006, Mr. Witherspoon had a painting with a fair market value of $1 million, in which he transferred an undivided 10% interest to the Guggenheim Museum. Mr. Witherspoon's charitable income tax deduction will be $100,000 in 2006, and post-transfer, he still retains an undivided 90% interest in the painting. Sotheby's manages to sell a painting by the same artist for a record sum at its spring auction and the value of Mr. Witherspoon's painting suddenly spikes to $1.3 million. In autumn of 2007, Mr. Witherspoon makes an additional gift of an undivided 10% interest in the painting. Despite the fact that 90% of $1.3 million is $1.17 million, and 10% of that amount is $117,000, Mr. Witherspoon's charitable income tax deduction is limited to $90,000 under the new valuation rules.

Assume further that Mr. Witherspoon unexpectedly passes away in 2008 and his estate owns an 80% interest in the painting on his death. The fair market value of the painting has appreciated to $1.5 million, so for federal estate tax purposes the estate's 80% interest is worth $1.2 million. Mr. Witherspoon's will specifically bequeaths his remaining interest in the painting to the Guggenheim, and so the bequest qualifies for the estate tax charitable deduction. However, because of the PPA, the estate's tax deduction is limited to 80% of $1 million, or $800,000. Because of the mismatch created by the PPA the painting, although donated in full to the Guggenheim, actually causes estate tax. Unless there is an agreement requiring the Guggenheim to help pay the estate tax bill or some other arrangement, Mr. Witherspoon's descendants, the estate's remainder beneficiaries, will likely be paying the price.

Compare the foregoing scenario with what would have happened if Mr. Witherspoon had decided against making the fractional interest gift in the first place, but instead bequeathed 100% of the painting to the Guggenheim. The estate would include the full fair market value of the painting of $1.5 million, but the entire fair market value would qualify for the estate tax charitable deduction.

In addition to the potential mismatch described above, the PPA requires that charitable income tax deductions be "recaptured" if the donor does not transfer all of his remaining interest in an artwork to the charitable organization (or another donee organization, if the original has ceased to exist) within ten years after the date of the initial fractional interest gift or, if earlier, as of the donor's death (the specified period). Recapture is also triggered if the charitable donee has not taken substantial physical possession of the artwork within the specified period. Even more punitive still, when recapture applies, the PPA imposes a 10% penalty on the amount recaptured.

Highly appreciated art remains an ideal asset for charitable giving under many circumstances. However, gifts of fractional interests will no longer be as appealing to most wealthy individuals. As disappointing as the change may be for charitable donors, it is likely to seriously impact museums, particularly smaller organizations, which will find it impossible to purchase art on the ever-escalating market. Legislators who allege fractional interest gifts merely confer an undeserved tax benefit to the wealthy should consider this: A gift of a fractional interest in a Cezanne or a Rembrandt is a gift and commitment to the general public of the entire painting-a one-of-a-kind masterpiece that, but for the fractional interest gift, is likely to be stashed away from public view in a private collection.

Those collectors who have made fractional interest gifts in the past should be actively engaged with their tax advisors and their museum development officers in discussions about the effect of the PPA on charitable giving arrangements already in place.

Richard J. Flynn is principal of the accounting and business management firm Rothstein Kass and head of the RK family office group.