The majority — 62% — of art purchases
There are three taxes that are relevant to art collectors: the federal capital gains tax, currently 28%; the net investment income tax, 3.8% for single taxpayers with income over $200,000 or married filing jointly with income over $250,000; and the gift and estate tax, 40% after the $12.92 million exemption, which falls to $5 million after 2025.
So, for a sale of art for a single collector with income over $200,000, the total federal income tax would be 31.8%, and the gift or estate tax for a taxable estate is 40%. The non-tax costs of selling art add to the burden, with the seller's commission ranging from 10% to 25%. This means that on the sale of artwork with a hammer price (the winning price offered at an auction) of $1 million, the net proceeds to the collector are $750,000, of which $285,750 is due in income taxes, an after-tax amount of $464,250, or more than half of the hammer price going to taxes and fees.
Unlike real estate investments, there are no tax-free exchanges of artwork. But there are some alternatives to defer the payment of the capital gains tax.
CRATs and CRUTs
A charitable remainder trust is the best way to defer paying capital gains tax on appreciated assets, if you can transfer those assets into the trust before they are sold, to generate an income over time.
When a
Gifts made to a CRAT qualify for income and gift tax charitable deductions and, in some cases, an estate tax charitable deduction for the remainder interest gift, if the trust meets the legislative criteria. The annuity paid must either be a specified amount expressed in terms of a dollar amount (e.g., each noncharitable beneficiary receives $500 a month), a fraction or a percentage of the initial fair market value of the property contributed to the trust (e.g., the beneficiary receives 5% each year for the rest of his or her life).
You will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity, from the fair market value of the property and/or cash placed in the trust. The balance is the amount that the grantor can deduct, when the grantor contributes the property to the trust.
A charitable remainder unitrust, or CRUT, is similar to a CRAT, except that instead of a fixed dollar amount or percentage of the original gift amount, the annuity is a specific percentage of the balance of the trust assets as of the beginning of the year the payments are to be paid.
An example of the tax savings using a CRAT:
- Value of artwork: $1 million
- Term of annuity: 10 years
- Current AFR rate: 5%
- Tax savings in the year of the sale: $318,000
- Annual payment: $116,554.63
- Immediate charitable deduction: $100,000.11
CLATs
A charitable lead trust is the best way to accelerate charitable deductions to both reduce the negative effects of the new limitations on itemized deductions and to offset up to 50% of your adjusted gross income in any tax year. It can also be used as a way to eliminate gift or estate taxes on transfers to children or other beneficiaries.
Creating a charitable lead annuity trust, or CLAT, requires transferring cash or other assets to an irrevocable trust. A charity receives fixed annuity (principal and interest) payments from the trust for the number of years you specify. At the end of that term, assets in the trust are transferred to the noncharitable remainder person (or persons) you specified when you set up the trust. This person can be anyone — yourself, a spouse, a child or grandchild, even someone who is not related to you.
You can set up a CLAT during your lifetime or at your death. Both corporations and individuals may establish lead trusts, which is useful when you need to take appreciated assets out of a business tax-free.
If you are the beneficiary, then you will receive an immediate and sizable income tax deduction. In the second and following years, you must report the income earned by the trust, less the amounts actually paid to the charity in the form of an annuity.
One advantage of the CLAT is the acceleration of the charitable deduction in the year you make the gift, even though the payout is spread out over the term of the CLAT. For example, if you have sold a highly appreciated asset this year, but you can reasonably expect that in future years your income will drop considerably, you can have a very high deduction in a high bracket year, even if you have to report that income in lower bracket years. You are able to spread out the income (and the tax) over many years.
Another advantage of the CLAT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainder man must wait for the charity's term to expire; therefore, the value of that remainder man's interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered, because the value of the gift is decreased by the value of the annuity interest donated to charity.
When the assets in the trust are transferred to the remainder man, any appreciation on the value of the assets is free of either gift or estate taxation in your estate.
A charitable lead unitrust is similar to a charitable lead annuity trust, except that the payout to charity is a percentage of the trust assets at the beginning of the year in which the annuity payments are to be made.
An example of a CLAT for estate taxes:
- Donation to the CLAT : $1 million
- Term of CLAT: 10 years
- Growth of assets in CLAT: 8%
- Annual payout to charity: $72,999.47
- Remainder passing to your heirs tax free: $1,016,813.00
- Estate tax savings: $400,000
Both techniques require careful drafting and careful administration to comply with the requirements of the IRS, but the savings make it well worth considering. Additionally, by leveraging a charitable gift, one can avoid incurring the income and gift tax burden for those baby boomers and older clients who are planning for the sale or transfer of their collections.
