In mid-November a portrait of a young Vietnamese woman by the artist Gustav Klimt, which was part of the estate of the late Leonard Lauder (the cosmetics billionaire), was sold at a Sotheby’s auction for $236.4 million. It set the record for the most expensive work of modern ^[1]art ever sold at auction according to Bloomberg^[2]. That’s probably out of reach for most of our clients. But what if they could join together to buy an interest in the painting with an entity holding the asset? That’s the idea behind the burgeoning fractional art market. While, in general, the art market has been struggling for a few years, the fractional art market has been expanding. According to the website Digital Original, “Fractional art ownership is no longer a niche concept – it’s a growing investment trend that’s accessible, flexible, and supported by cutting-edge technology.”^[3] What, you may be asking, does this have to do with taxes? It may be more than you think for your high-net-worth clients. As a trusted advisor it’s important that you are aware of both the types of investment opportunities your clients may be buying into and the tax consequences.

Fractional art investments have three potential financial benefits each of which have tax consequences for investors:

• Potential income from licensing or renting the property
• Potential for long-term capital gain on an appreciated asset
• Potential for a valuable non-cash charitable deduction

One hopes that clients would “read the fine print” before pursuing such an investment opportunity and then discuss the potential tax consequences with their trusted tax advisor (you). Or you may have attended the recent Winter Series Webinar presented by Chase Ravsten, Vice President of Vistia Capital—a firm that specializes in connecting HNW investors with opportunities to build and protect wealth—and are thinking about how the investment opportunity presented in the webinar could benefit your HNW clients.

Vistia’s Opportunity Overview

The opportunity presented by Vistia is not technically a fractional art investment. It is, rather, fractional art adjacent. According to the brochure, “Investors participate through a fund structured to acquire up to 95% membership interest in Midsouth Archives Acquisition Fund, LLC.” Midsouth purchases photographic archive collections in bulk and then curates and digitizes the archives for investment purposes. It provides interested investors with the opportunity to “preserve cultural capital” while also either making some money or saving on taxes. This particular investment will allow members to choose how the entity will benefit from the assets being held.^[4]

Income from Licensing or Renting the Property

The art in the 1986 film Legal Eagles was all original—and rented.^[5] One of the possible income sources for investors in the fractional art market is from licensing the use of images for which the investment company holds the copyright (or for which the copyright has expired) and/or from renting the asset(s) to movie studios, event planners, high-end real estate agents, etc.

It’s important for tax professionals to remind their clients that income from this type of investment is going to be ordinary income subject to the amount of tax in their bracket. It could be a mindful decision for certain clients who want income-producing investments but who maybe want to get away from “the usual suspects” with respect to dividend income.

Long-term Capital Gain

Depending on the company, renting and licensing could also provide the operating funds for the entity while the longer-term plan is to hold the assets and then sell them at auction (or whatever). As above, where the investment provided income portfolio diversification, investing in fractional art where the business model is buy, hold, sell at a highly appreciated price, could offer high-net-worth clients the ability to diversify beyond their normal portfolio of “buy and hold” stocks. It is important to remember, however, that the market for purchasing art is highly subjective (i.e., volatile) and that investments could go way down before they eventually (or never) come back up.

Nevertheless, for client investors who are aware of the risks, there could be significant rewards to this type of investment. First, their income would be long-term capital gain, which as we all know gets favorable tax rates compared to ordinary income. Additionally, if the shares in the investment opportunity are inherited they get stepped up basis. Also, don’t forget that a spouse in a community property state can also get stepped up basis for the deceased spouse’s 50% of the investment.

Non-cash Charitable Deduction

Alternatively, the fractional art investment could be set up as a tax shelter that provides a tax-deductible charitable donation that exceeds the amount of the investment. For example, the Vistia-brokered investment is not exactly fractional art (only some of the photographs in the acquired archives have art-level subject matter and quality) but it is structured to provide a charitable deduction in excess of the original investment (should the members agree that the donation option is the preferred way of using the assets).

Unfortunately, when being used to generate a charitable donation in excess of the original investment, fractional-art investments are also structured similarly to the much-maligned syndicated conservation easements, which routinely find their way onto the IRS’ annual Dirty Dozen list. Does that automatically mean that the opportunity should be dismissed? Not necessarily.

For example, does the IRS consider transactions involving contributions of art as “substantially similar” to contributions of real property for the purposes of determining whether the contribution is a listed transaction? According to the final regulations on syndicated conservation easements as listed transactions, the answer to that question is no:^[6]

The Treasury Department and the IRS have determined that such transactions are not “substantially similar” for purposes of these final regulations because this listed transaction relates to contributions of real property, not of personal property.

A full discussion of what it means to be a transaction that is “substantially similar” to a syndicated conservation easement can also be found in the final regulations. Nevertheless, the regulations keep open the option for the IRS and the Treasury Department to reclassify other transactions, including donations of fractional interest in art assets, as listed transactions.

What this means is not that your clients should avoid an available tax shelter or investment opportunity, but rather, that they should understand the risks associated with the investment, including the risk that the investment could be challenged in exam or in court and what would happen to their tax returns if they do not prevail.^[7]

The V Word

In real estate it’s location location location. When it comes to art everything hinges on valuation valuation valuation. Interestingly (but not surprisingly) when it comes to art valuation, the IRS usually wants to have it both ways. When art is valued for estate tax purposes, under exam or in court the IRS often insists that the art is worth more than the stated valuation. When art is appraised for the purposes of a non-cash charitable contribution or to determine long-term capital gain on its sale, however, the IRS typically insists that the art is worth less than the amount taken as a charitable deduction or, in the case of a sale of an interest, the amount of the stated stepped-up basis. Consequently, it is important for clients to understand how the valuation and/or appraisal of the asset(s) is being done and by whom.

For example, Midsouth has used more than one valuation firm. The firms value the physical photographs based on comparable sales and using auction data.^[8] Midsouth is also familiar with the IRS rules for who is considered a qualified appraiser and qualified appraisals and makes sure that the valuations are done by a qualified appraiser and provided in writing by any applicable deadlines (e.g., before a photograph is sold or donated).^[9]

Best Practices^[10]

In a perfect world, our clients discuss the tax consequences of large investment opportunities before they invest. When this happens, your role as a trusted advisor would be to ensure that the client—

• Understands what type of property is being held (NFT, copyright, physical asset)
• Understands the investment goal or goals (income, long-term capital gains, tax deduction)
• Understands how the property is being valued and, if possible, by whom.
• Understands the risks associated with the investment (losing their money or losing the deduction^[11]).
• Can provide you with the documentation necessary to prepare an accurate tax return including substantiating the character of any income that must be recognized and substantiating the value of any deduction taken.^[12]

It is also helpful to remind clients that the lines of communication are always open and that they should consult you, if not before they invest, then at least before their investment incurs any tax consequences. For income-producing investments that could be in the same tax year as the investment is made; for “buy and hold” investments it could be several years down the road; and for charitable donation tax shelters it could be relatively immediate or in the more distant future. But in any case, there is no tax planning without pro-active communication.