A Dose Of Realism

As appeared in PrivateWealth 

For many collectors, artwork can be far more than something to enjoy and display for the pleasure of others. It can be a valuable and even important component of a well-diversified investment portfolio. Indeed, in some cases, art collectors can achieve substantial, non-correlated returns if they can acquire the requisite expertise in this often-neglected sector.

From a financial planning perspective, art collectors must be aware of the various financial considerations involved in acquiring, owning and selling artwork. Given the myriad investment, tax, insurance and estate planning issues associated with owning artwork, it rarely is sufficient for a collector to confer solely with an art dealer.

Collectors need to be just as vigilant as successful investors in stocks and bonds, with a thorough knowledge of the financial implications of owning such assets.

Collectors, for example, need to be aware that artwork, unlike some securities, can be expensive to buy or sell, difficult to value and typically illiquid.

Often, it must be bought or sold through an auction house, dealer or agent.  Transactions can involve high premiums, commissions and other sales-related expenses, especially when compared with the fees associated with stocks, bonds and other traditional asset classes.

In private sales, many of these transaction expenses can be avoided, but valuation may in turn become far more challenging. In fact, even in a public auction, there is no guarantee that an established sale price represents actual fair market value. Art is unique by nature, making valuation highly subjective and susceptible to relative volatility.

The general illiquidity of artwork is also an important consideration because it presents an additional risk for those who might unexpectedly find themselves in need of capital. The potential illiquidity of any investment must be carefully considered in a financial portfolio.

Insurance Is Vital
The carrying costs of owning artwork can greatly exceed the costs of owning more traditional investments. Valuable artwork simply must be insured and, therefore, it must also be appraised on a periodic basis. (While not an insignificant expense, an experienced, knowledgeable appraiser can be an extremely valuable addition to an art collector’s team of trusted advisors.)  Artwork can also attract other carrying costs for maintenance, storage, security, etc.

Additionally, many localities subject artwork to personal property taxes, especially if it is displayed or stored in a second home or in a place of business. Personal property taxes are usually based on an assessment of fair market value, again making it necessary to have appraisals performed.

While these carrying costs may be justifiable from an investment perspective, they must all be accounted for in understanding the real return on the asset in question. It is worth noting that, barring a lease or similar arrangement, artwork does not offer a current monetary return, such as a dividend or interest payment, to offset the applicable carrying costs. Of course, it does offer certain non-financial returns, such as personal enjoyment, but these returns are subjective and can only be valued by the individual investor.

Unique Risks
Owning artwork carries atypical risks. In addition to obvious risks such as fire and theft, the artwork is also subject to fraud, a lack of market regulation and sometimes an inability to obtain full insurance protection.

The purchase of artwork may also be a taxable event, sometimes unbeknownst to the collector. While federal taxes (e.g., customs duties) generally do not apply to the purchase of artwork, state taxes are another matter.  Specifically, artwork purchased in a particular state for use in that same state may be subject to sales taxation, and artwork purchased in a state for use in a different state may be subject to use taxation by the destination state.

Most states subject the purchase of artwork to their sales taxes, which can be quite substantial. In general, however, provided that the appropriate procedures are followed, a purchaser may be able to avoid having sales taxes collected by a seller by demonstrating the applicability of a sales tax exemption, such as for an item of artwork that is being purchased as part of a casual and isolated sale.  Sales taxes often can also be avoided by demonstrating that the item purchased will be stored or displayed in a different state.

The latter exception, however, typically means that the purchaser will have to pay use taxes, which also can be substantial, in the destination state. Many purchasers are unaware of this requirement, but states increasingly are aggressive in imposing their use taxes on items purchased out of state, and collectors should be aware of their obligations to pay use taxes when applicable.  States may seek to impose interest and penalties on late payments of use taxes.

Taxing Issues
The sale of artwork may be taxable at rates that are higher than those applicable to other assets. While current tax laws dictate the treatment of a seller of artwork based on each seller’s individual facts and circumstances, an item of artwork sold by the typical collector is treated as a collectible. Therefore, its sale generally is subject to federal income taxation at a long-term capital gains rate of 28%, or 8 percentage points higher than the maximum rate of federal tax on capital gain recognized upon the sale of non-collectibles. Moreover, the sale of artwork may be subject to even higher rates of taxation if the artwork has been held for one year or less at the time of sale or if someone who is treated as a dealer sells the artwork.

Moreover, artwork may create significant estate and gift tax challenges. Because artwork typically is illiquid and difficult to value, and the laws governing the transfer of artwork are complicated, owning artwork can present challenges in the areas of estate and gift taxation and related planning. A failure to secure accurate, reliable appraisals can lead to flawed plans and ultimately to challenges by federal and state taxing authorities regarding the application of any estate and gift taxes. Compounding the problem further, a failure to fend off such challenges can be exacerbated by the inability to liquidate the artwork to pay any resulting taxes, interest and penalties. In addition, transfers of artwork to charitable entities or family members must be conducted within a strict set of legal regulations. The failure to transfer artwork within these regulations can put a collector’s overall financial and estate plan at risk.

Again, as stated above, artwork can be far more than an investment, and collectors must always subjectively account for the benefits associated with their holdings. Yet the best advised, most prudent collectors will also find a way to consider the objective aspects of collecting artwork, thereby ensuring that their collections are also good investments and holistically integrated into their overall financial plan.