Editor's Note: The following article is a preview of a presentation to be given at the 46th Annual Heckerling Institute On Estate Planning conference, which will be held January 9-13 in Orlando, Fla.

The lifetime transfer of a work of art to a charitable organization saves the donor income taxes because of the allowable income tax deduction.

For example, a painting that cost a collector $1,000 some years ago may have a fair market value of $10,000 today.  A contribution of the work of art to a public charity produces a charitable deduction of $10,000.  For someone in the 35% tax bracket, such a contribution saves $3,500 in federal income taxes.  Since the donor's out-of-pocket cost was only $1,000, he has made a $2,500 profit and has enjoyed the use of the work of art through his years of ownership.

Generally, a deduction is allowed for the full fair market value of a work of art that is donated to a charitable organization under four conditions:
1. The work of art must be contributed to a public charity, not a private foundation.
2. The work of art must be long-term capital-gain-type property and not ordinary-income-type property.  This means the donated property must be a capital asset that you owned for more than one year.
3. The work of art must satisfy the related-use rule-the use of the work of art by the donee charity must be related to the tax-exempt purpose of the charity.
4. The donor must obtain an appraisal of the work of art by a qualified appraiser.

The amount of the allowable deduction in any one taxable year cannot exceed 30% of the donor's adjusted gross income.  Any excess above the 30% limitation can be carried forward for five years and deducted in those years until the deduction is used in full.

For example, if a taxpayer has on adjusted gross income of $100,000 the maximum charitable deduction for a contribution of an appreciated work of art is $30,000. If the work of art contributed has a fair market value of $50,000, the $20,000 excess can be carried over and be used as a deduction in the following year.

If the art is sold instead of donated, the federal long-term capital gains tax rate is 28%, not the 15% that currently applies to the sale of stock, bonds and real estate.

Related Use Of Donated Property
The Pension Protection Act of 2006 (PPA) added new Internal Revenue Code section 170(e)(7)(A), which says that if a charitable organization receives appreciated tangible personal property as a charitable contribution and disposes of the property within three years of receiving it, the donor may not derive any tax benefit beyond a deduction in the amount of the property's basis.  However, this rule will not apply if the donee provides a "certification" that the property was intended to be used or was put to a use related to the donee's exempt purpose.

The related use rule applies to capital gain property that is tangible personal property contributed to a public charity. The term "tangible personal property" includes paintings and art objects not produced by the donor. The related use rule requires that the use of the tangible personal property by the donee be related to the nonprofits' purpose or function. If the use of the collection by the donee organization is unrelated to this purpose, the charitable deduction must be reduced by 100% of the appreciation in the value of the collection. After the reduction, the remainder may be deducted by up to 50% of the taxpayer's contribution base.

If an item is donated for an art auction to be run by the charity, for example, this is an unrelated use, and 100% of the appreciation in value is lost as a charitable deduction.


Here are a few other examples of how a contribution may or may not qualify for a deduction.
A painting is contributed to an art museum that is a public charity. From   time to time, the museum displays the painting prominently and publicly. This satisfies the related use rule. The contribution is deductible to the      extent of the fair market value of the property within the 30% limitation.
If the same painting is contributed to the Red Cross, a public charity that from the outset intends to sell it and promptly does, the deduction must be reduced by 100% of the appreciation in value, with the balance deductible within the 50% limitation.

Related Use Reporting
Under the PPA, the IRS requires the donee charity to file Form 8282 if it disposes of the property within three years after receipt. The information that must be reported includes a description of the donee's use of the property and a statement indicating whether its use was related to its purpose or function.  If the donee charity does indicate a related use, it must include a certification.

The claim that donated property was put to an exempt use triggers much more scrutiny if the donee organization does not retain that property at least until the end of the third year after the property was donated.

These new rules do not apply to any contribution of exempt use property with a claimed value of $5,000 or less.

Any person who identifies applicable property as having a use that is related to the donee's exempt purpose or function and who knows that the contributed property is not intended for such a use is subject to a $10,000 penalty.

Qualified Appraisal
The PPA revised the definition of a "qualified appraisal" to mean an appraisal of property that is:
a. treated as a qualified appraisal under the regulations or other guidance prescribed by the IRS; and
b. conducted by a qualified appraiser in accordance with generally accepted appraisal standards.

The existing IRC regulations still apply, requiring that the appraisal not be prepared more than 60 days before the date of the contribution of the property and that the appraisal be signed and dated by a qualified appraiser whose fee is not based on the property's value.  The appraisal must contain the following information:
1. A detailed description of the property.
2. The physical condition of the property.
3. The date or expected date of the contribution.
4. The terms of any agreement or understanding entered into or expected to     be entered into by or on behalf of the donor that relates to the use, sale or other disposition of the property contributed.
5. The name, address and taxpayer identification number of the appraiser.
6. A detailed description of the appraiser's background and qualifications.
7. A statement that the appraisal was prepared for income tax purposes.
8. The date on which the property was valued.
9. The appraised fair market value of the property.
10. The method of valuation used to determine the fair market value.
11. The specific basis for the valuation, such as any specific comparable sales transactions.
12. A description of the fee arrangement between the donor and the appraiser.

The appraisal must be received by the donor before the due date (including extensions) of the taxpayer's income tax return. That deadline is important, since the entire charitable deduction is lost if the taxpayer does not comply with that provision.

Qualified Appraiser
The PPA now includes in the IRC a definition of a "qualified appraiser" to mean an individual who:

a. has earned an appraisal designation from a recognized professional appraiser organization, or has otherwise met minimum education and experience requirements set forth in regulations;
b. regularly performs appraisals for pay; and
c. meets other requirements that the IRS may prescribe in regulations or other guidance.  

An individual cannot be considered a qualified appraiser unless he:
a. demonstrates verifiable education and experience in valuing the property type being appraised; and
b. has not been prohibited from practicing before the IRS at any time over the past three-year period ending on the appraisal date.

It is imperative that the donor check the credentials of the appraiser to ensure he is an expert in the item being appraised. An expert appraiser for a Dutch 17th century drawing, for example, will not be an acceptable appraiser for a work of contemporary art.

Furthermore, if a person acquired a painting from an art dealer and later donated the painting to a museum, the donor, the dealer who sold the painting, the museum, any person employed by the donor or the dealer or the museum, or a person related to any of these parties is not a qualified appraiser. The regulations are so broad that they appear to disqualify an auction house from being a qualified appraiser if the donor purchased the property at auction from that auction house. A donor could lose his entire deduction if an appraiser is found to be unqualified later.

IRS Guidance
Notice 2006-96, issued by the IRS in October 2006, offers some guidance on the new appraisal rules introduced by the Pension Protection Act.  According to the notice, an appraisal will be treated as qualified under the new rules if the appraisal complies with all the requirements of the existing IRS regulations and is conducted by a qualified appraiser in accordance with generally accepted appraisal standards.  An appraisal is treated as having been conducted in accordance with generally accepted appraisal standards if, according to the notice, the appraisal is consistent with the substance and principles of the Uniform Standards of Professional Appraisal Practice (USPAP), as developed by the Appraisal Standards Board of the Appraisal Foundation.

An appraiser will be treated as having demonstrated verifiable education and experience in valuing the type of property subject to the appraisal if the appraiser makes a declaration in the appraisal that, because of the appraiser's background, experience, education and membership in professional associations, the appraiser is qualified to make appraisals of the type of property being valued.  For appraisals for returns filed after February 16, 2007, the appraiser will be treated as having met the minimum education and experience requirements if the appraiser has (i) successfully completed college or professional-level coursework that is relevant to the property being valued, (ii) obtained at least two years' experience in the trade or business of buying, selling or valuing the type of property being valued, and (iii) the appraiser gives a full description of his educational background.

Fractional Gifts
The IRS was concerned that there was abuse of the "fractional gift" technique- situations were discovered where a taxpayer claimed a deduction for a fractional interest in a work of art yet retained physical possession of the donated property for the full year.  Under new rules introduced by the PPA, effective for contributions made after August 17, 2006, fractional gifts are no longer desirable because of the valuation limitation.

The collector's initial contribution of a fractional interest in a work of art is the full fair market value times the fractional interest donated.  For purposes of determining the deductible amount of each additional contribution in the same work of art, the fair market value of the donated item is now limited to the lesser of: (1) the value used for purposes of determining the charitable deduction for the initial fractional contribution; or (2) the fair market value of the item at the time of the subsequent contribution.

For example, the collector who gives away a 50% interest in a painting when it is worth $1 million would still be able to claim a $500,000 deduction.  However, when the collector donates the remaining 50% interest ten years later, when the painting is worth $2,000,000, the collector's donation would be limited to 50% of the initial fair market value, rather than half the $2 million current value.
Ralph E. Lerner is an attorney at Withers Bergman LLP in New York City. He practices in the area of art law, working with auction houses, consignment agreements and tax planning for items of tangible personal property.


Ralph E. Lerner is an attorney at Withers Bergman LLP in New York City. He practices in the area of art law, working with auction houses, consignment agreements and tax planning for items of tangible personal property.