Gift or bequest?

Since the Tax Cut and Jobs Act of 2017 (the Act) was enacted, wealthy taxpayers have been making large gifts to beneficiaries, or to trusts for beneficiaries, in order to soak up their temporarily increased lifetime gift exemption amount before it resets back to its 2017 level (adjusted for inflation). Rather than giving away stocks and bonds or parting with real property interests, many collectors have used their fine art to make lifetime gifts to beneficiaries.

Under the Act, the exemption amount (the cumulative amount that U.S. persons can give away during their lifetime and/or at their death) doubled from $5.49 million in 2017 to $11.18 million in 2018, and is to be adjusted annually for inflation — but only until 2026, when the exemption must revert back to $5 million, adjusted for inflation. The 2023 inflation-adjusted exemption amount is $12.92 million per taxpayer ($25.84 million per married couple). Failure of wealthy collectors to use their increased exemption amount before it sunsets back to $5 million in 2026 is estimated to cost collectors’ heirs approximately $2.84 million ($5.6 million if the collector is married) in federal estate tax.

Tax considerations

When collectors give away artwork during their lifetime, the gift will be free from gift tax as long as the artwork isn’t more valuable than a collector’s unused lifetime exemption amount. The gift will remove the fair market value of the artwork from the collector’s estate as well as any future appreciation. While recipients of the gift don’t have to recognize income, they’re required to take the donor tax basis in the artwork, called the carryover tax basis, if the artwork had appreciated in the donor’s hands.¹ If the gifted artwork is later sold by the recipient, the gain (if any) will be determined by subtracting the carryover tax basis from the amount realized.

Scenario 1

The result

• The painting and its future appreciation are removed from Carl’s estate.
• The daughter doesn’t have to report the gift as income.
• Carl must file Form 709: U.S. Gift (and Generation- Skipping Transfer) Tax Return to report the gift, and use some or all of his remaining exemption amount to make the transfer gift-tax-free.
• When the daughter sells the painting, she must report a $1.4 million capital gain on her personal tax return ($1.5 million amount realized, less $100,000 tax basis).
• The daughter’s capital gain will be considered long- term, even though she didn’t hold the painting for more than one year, because she can combine her holding period with her donor-father’s holding period (called “tacking holding periods”) since she received the painting as a gift.
• The long-term capital gain rate for collectibles is 28%. The daughter would owe $392,000 and clear $1,108,000 after tax.²

It’s worth noting that, had Carl made the gift with depreciated art (that is, the fair market value at the time of the gift was less than Carl’s tax basis), his daughter’s adjusted basis in the artwork would depend on whether she sells the painting for a gain or a loss. If she sells the painting for a gain, her tax basis will be equal to Carl’s tax basis. If she sells the painting for a loss, her tax basis will be the fair market value at the time of the gift, adjusted for certain required basis adjustments. She may not have a gain or loss if she sells it at an amount between her tax basis and the fair market value at the time of the gift, as adjusted.

On the other hand, had the work of art been transferred at Carl’s death, the daughter would have received the art with a “stepped up” tax basis, as long as the art had appreciated between the time Carl purchased it and his date of death. Because of this so-called “carryover basis rule,” collectors tend to use cash and/or works of art with a higher tax basis for lifetime gifts so that their low basis art can remain in their estate and receive a stepped-up tax basis at death.

Scenario 2

The result

• The painting and the resulting after-tax sales proceeds are in the daughter’s taxable estate.
• The daughter doesn’t have to report the bequest as income.
• Carl’s estate must file Form 706: U.S. Estate (and Generation-Skipping Transfer) Tax Return to report the bequest, and use some or all of Carl’s remaining exemption amount. If no exemption amount is available, the painting will be subject to a 40% estate tax on its entire value.
• When the daughter sells the painting in 2023, she must report a $500,000 capital gain on her personal 2023 individual tax return ($1.5 million amount realized, less $1 million stepped-up tax basis).
• The daughter’s capital gain will be considered long- term, even though she didn’t hold the painting for more than one year, because property received through an estate is automatically deemed long-term property.
• The long-term capital gain rate for collectibles is 28%. The daughter would owe $140,000 and clear $1,360,000 after tax.³

Liquidity considerations/solutions

Collectors occasionally need liquidity for a whole host of reasons and often look toward their collection as a potential source of funds. Essentially, they have two choices when monetizing their collection: They can sell some works, or if their art qualifies, they can leverage their art by obtaining a so-called “art loan.”

Using leverage to take advantage of the temporarily increased exemption amount instead of selling appreciated art, removing it from their collection and generating income taxes, many collectors use loans backed by their personal collections. This allows them to secure the cash they need to make lifetime gifts that’ll soak up their temporarily increased exemption amount so they can keep the appreciated art in their collection. Ultimately, they’ll receive a stepped-up tax basis at their death so their beneficiaries will have the option to immediately sell the work(s) without generating capital gains, due to the step up.

Bank of America, N.A., is one of the most active lenders against fine art in the world. If you’re interested in using your collection to produce liquidity without selling, please reach out to your advisor.