is a story about two paintings and the Internal Revenue Code (the
"Code"). The paintings were done by the same artist, painted during the
same period, and are of comparable value. The owner of the first
painting was able to fully deduct the costs of upkeep, climate control,
security and insurance on his painting, as well as travel and other
expenses pertinent to acquiring the painting on his federal income tax
return, while the other owner incurred the same costs but received none
of the same tax benefits. What is more, if the first painting were sold
at a loss, its owner could deduct the loss for tax purposes, while the
owner of the second painting would receive no benefit from the loss.
The reason for such disparate treatment under the Code? The first owner
was an Investor while the second owner was a Collector.
Income Taxation Of Art
For assets held more than one year, the federal capital gains rate is typically 15%. This rate would be applicable to stocks, bonds, real property and most other investment assets. Works of art, however, are deemed "collectibles" and are taxed at 28%. The gain on the sale of a Picasso will be taxed at 28%, while the gain on IBM stock will be taxed at 15% as long as the holding periods for both assets are more than one year. For reasons known only to Congress, gains on art are subject to tax at a rate that is nearly double that of most other investment assets.
Because the eventual gains from the sale of a work of art are highly taxed, it is important to deduct the extensive and expensive holding costs associated with owning a significant art collection. Important pieces of art are frequently valued in the tens of millions of dollars. Whether the owner has owned the work for decades or has recently purchased it at auction, he or she will certainly want to protect and maximize the investment.
In recent years, the cost of maintaining a great work of art has soared along with the value of the art itself. It is only logical that the cost of insurance on an asset will increase as the value of the asset rises. Installing proper climate controls that can regulate temperature and humidity, lighting that will not damage the work and state of the art security systems all require significant outlays of capital, as well as ongoing annual costs. The costs of appraisals, research materials, art books, periodicals, framing, maintenance and travel to purchase and sell art all add up. There is a tremendous advantage if these costs can be deducted or depreciated.
Investor Vs. Collector
An investor buys and sells works of art with the principal intention of achieving a profit. A collector buys and sells works of art principally for his or her personal pleasure. Profit is not a collector's primary motive. There is rarely a single motivation behind the purchase of a work of art, but to achieve investor status, the motivation of first importance must be a profit motive. Motivations are largely subjective and an investor may have a love for art as a secondary motive. Given the large financial commitment necessary to obtain world-class art, individual purchasers and owners today are keenly aware that art is a quality alternative investment asset that has a very good track record, and appreciation potential is a significant motive in buying artwork. How then does the purchaser or current owner demonstrate that profit is his or her principal motivation, and therefore obtain the benefits of being an investor and not a collector?
Whether an individual purchased a work of art as a collector or an investor is a subjective conclusion, but it will be largely determined by objective factors which indicate the taxpayer had a primary (although not necessarily exclusive) intention to make a profit. The regulations promulgated under the Code and interpreted by the courts give the taxpayer a clear set of tests to be satisfied to establish investor status. With a little effort, it is fairly easy to demonstrate that purchasing a work of art was done primarily with a profit motive and perhaps secondarily, for the love of art itself.
To maximize the factors that prove investor status, the taxpayer should carry on his art activities in a business-like manner with complete books and records. This is a very important factor in determining whether the taxpayer is an investor as opposed to a collector. For example, is there a separate checking account for art expenses and purchases? Has a market analysis been done on a piece of art prior to its purchase? Organization and a systematic approach are key.
The taxpayer should demonstrate expertise, a commitment to self-education and/or a reliance on professional advisors. Did the taxpayer or his advisors promote and market the collection or featured artist, securing appropriate display opportunities to maximize the eventual price of the art on sale? Does the taxpayer subscribe to auction catalogs and trade publications? Are the values of individual pieces in the collection reappraised regularly by professional appraisers? Does the taxpayer spend significant time and effort on his or her collection and is that commitment documented by a diary or journal describing the taxpayer's visits to auctions, galleries and museums, and his or her scholarly research, and discussions with experts?
A track record indicating that the taxpayer has profited on sales of pieces from his or her collection is a good indication of a profit motive. The larger the gains, the better the indicator. In many cases, pieces will not yet have been sold. In that case, the expectation of profit must be real but it need not be "reasonable." The owner of the art must believe a profit is attainable and conduct his or her art activities accordingly, but an objective observer need not believe a profit is likely. Another good indication of a profit motive is a change in strategy if after a period of time the collection is not profitable.
The absence of another occupation can provide a good indication of investor status, although for many taxpayers, significant outside wealth will be necessary to begin a world-class art collection. The existence of outside wealth should not be a major hurdle to Investor status, as long as a business like approach is pursued.
Finally, how much pleasure does the taxpayer experience from his or her collection? Because personal pleasure is often a motivation in embarking on the purchase or continued ownership of a work of art, care must be taken to carefully feature the primary motive of the purchase as profit. Self-serving statements are not definitive, but on occasion, can be helpful. Any statement should focus on the quality of the investment, and only mention the beauty or historical significance of the piece as a secondary motive for the purchase. Similarly, storing pieces outside of a personal residence is generally a better fact than if every piece of a collection is displayed in a taxpayer's home, but storing a collection at home is not fatal. If a taxpayer can prove that he or she is an investor as set out above, passion for art should not circumvent the determination of a profit motive. The Internal Revenue regulations acknowledge "[T]he fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit....".
No one factor is determinative; all facts and circumstances will be taken into account. If a taxpayer can prove he or she is an investor, ordinary expenses incurred to maintain, protect and maximize the value of the collection can be deducted regardless of whether the investor has any gross income generated by his or her art activities. If a taxpayer is not an investor but is only a collector, he or she can deduct expenses related to the art collection only up to the amount of gross income generated by the collection. Most collectors generate little or no gross income from their collection.
In either case, the benefit of the deduction may be reduced for some taxpayers by Code-based limitations on miscellaneous deductions and the phase-out of itemized deductions. Those limitations and phase-outs are scheduled to be repealed in 2011 and 2009, respectively.
Many owners of art are missing an opportunity to deduct significant costs they are incurring in maintaining their art collections. A love for the artist or period may be a factor in a decision to purchase a work of art, but if profit is the primary motive, and passion for the work is secondary, the taxpayer can achieve significant tax benefits by carefully arranging his or her affairs and documenting his or her art related activities.