The following article is reprinted with the kind permission of
Investment Advisor
Please note the article is written from the point of view of advice given to an investment advisor on how to help an art buyer.

The Art of the Deal
Tax Consequences of Buying and Selling Art

By Ginger Broderick , CPA

Cartoonist Al Capp once said that “abstract art is a product of the untalented, sold by the unprincipled to the utterly bewildered.” Whatever your personal views about art may be, it’s important to educate your artistically-minded clients about the tax consequences of buying and selling paintings, sculptures, and other works of art. Those who ignore tax issues risk having the federal government eventually own their collections.

The first step is to determine if the client should be classified as a collector, a dealer, or an investor.

The 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. If a collector must borrow money to purchase a work of art, he can no longer 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 his art to a museum, the fair market value of the deduction is identified as a charitable donation and Federal Form 8283 Noncash Charitable Contributions is filed with his personal tax return. However, this can be reversed under audit if the IRS learns that the collector purchased and donated multiple copies of the same print. The client would then be classified as a dealer and the deduction would be limited to a cost valuation.

A collector usually donates an item that has appreciated substantially in value. A common mistake is to accept a gift from the artisan 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 advise your client to pay for work by check or obtain a dated receipt for any cash purchases. The sale from an artist to your client, regardless of price, avoids the limitation of basis based on the artist’s cost of materials.

The Dealer

A dealer engages in the business of selling art. Your client has the burden of proving he is a dealer in order to deduct expenses that are ordinary and necessary and paid during the tax year. He must intend to earn income as a dealer, and must present himself as an art dealer. IRS problems can arise if dealer status is claimed by a part-time dealer with other sources of business income; in such a case, it could be argued that the activity is only a hobby. It is hard to prove a dealer status if all of the transactions are purchases.

It is also important to show sales with appropriate gross profit percentages, even if fixed costs and other operational expenses create a loss on the financial statements. To help prove dealer status, it is wise to 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. Most private art dealers are full-time because it may take several weeks or months to close a single deal. It should be noted that a dealer can donate art only at cost value and not the fair market value claimed by a collector.

The Investor

An investor is an individual who puts money into a business, real estate deal, or other asset for the primary purpose of producing income or profits. It is difficult to establish this status for tax purposes because the art investor obtains the benefits of being a collector and the benefits of being a dealer. The emphasis should not be on the visual enjoyment of art; an investor has a more passive interest in the work itself, and is primarily interested in the profit associated with selling the art. Most of an investor’s art is stored in locations other than the client’s home, or is on loan to a museum. The investor may well enjoy art but must be willing to sell the work once it has appreciated in value.

Tax Benefit on Sales

A significant concern is qualifying for the lower long-term capital gains tax on the sale of a work of art. The collector and investor are allowed, upon holding the work for the proper period, the favorable tax treatment. The dealer or artist is required to report the gain as ordinary income, regardless of any holding period.

The situation becomes more complicated when a dealer wants a dual status as an investor. If art is purchased at an auction, then sales tax should be paid and all accounting should be maintained in a separate corporation and bank account. It is good tax planning for a dual-status dealer/investor to establish separate insurance policies, storage facilities, and two different accounts at an auction house as well. It is important to segregate these activities in efforts to prove the fair market valuation taken on donated art to a charitable organization. Be sure to verify the status of a donee organization 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

If your client donates an item or group of similar items (stamps, coins, photographs, books, paintings) more than the fair market value of $5,000, he must obtain a qualified appraisal not more than 60 days prior to the donation date. This is required in order to claim a deduction on his tax return filed in the year of the donation. The appraisal summary must be signed and dated by the appraiser and be included in the tax return. The information contained in an appraisal includes a complete description of the art, name of the artist, approximate date created, cost and purchase date, history of the item, including proof of authenticity, physical condition, photograph of the artwork, expected date of contribution, terms of any agreement for the donation, name, taxpayer identification and qualifications of the appraiser, date of appraisal, and fair market value as well as the valuation method used in determining the fair market value (such as the income approach, the comparable sales or market data approach, or the replacement cost less depreciation approach). 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 appraiser. The 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 represent himself as someone who performs 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 may have the appraisal 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 to issue a statement of valuation approval if an artwork has been appraised at more than $50,000.

The request can only be made 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 the preparation and filing of the current year’s return. The application fee is approximately $2,500 for the first three items and $250 for each additional item.

The Art Advisory Panel

The Art Advisory Panel is a selected group of 25 outside professionals hired by the IRS to evaluate and challenge a taxpayer’s valuation of artwork in the $20,000+ category. The group members are prominent dealers, museum directors, and curators and 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 the prominence of an artwork can be possibly identified to a taxpayer’s collection. A panelist who has a conflict of interest on any level must excuse himself from the conversations. The panel meetings are closed to the public but a summary report is issued each year.

March 2003

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