I wrote this white paper for the Family Office Association. For online reading purposes, this white paper is divided into 4 chapters. There’s a link to Chapter 2 at the end of this chapter.
Art for Passion or Investment?
What begins as a passion and personal connection to art works by an individual in reality extends beyond being a personal interest. It is an important investment class to be monitored and continuously evaluated along with other significant asset classes such as real estate holdings. “Art transactions have recently accounted for over $60 billion annually.” Art prices have increased 50 to 100 percent over the past 50 years.  It is estimated that over $3 trillion worth of art is held in private collections.
The trend for increased transparency and accessibility to the art market through online technology, art dealers and galleries, auction houses and art fairs requires collectors to seriously consider art on their balance sheet and in their financial and tax planning. This growing trend of the “democratization” of art also demonstrates a growing public interest in and awareness of art. It can be viewed as an opportunity for Family Offices to promote their philanthropic vision through private museums, which can also benefit long-term family wealth goals. Culturally, such a strategy enables a family to share conversations about art not only amongst themselves and artists but also with the public.
This white paper presents perspectives on art held by Family Offices through the lenses of investment, tax, financing, legal and market advisory experiences. It suggests the importance of strategic and tax planning early once a decision is made to invest in art as a collector or investor. Without such planning families can face inadvertent tax and economic leakage that unnecessarily deteriorates their wealth and weakens familial bonds. These developments imply the need for Family Offices to focus on art as an investment class, including all of the associated risks and rewards of ownership.
Especially through technological developments, art would seem more accessible than ever to a wide audience to experience and enjoy. Given the focus on art as an investment class similar to real estate, it may be hidden away in structures to take advantage of tax incentives. Public museums are threatened by the reality of government cost cuts as arts funding assumes a lesser priority for federal funding. In certain cases, museums will be driven to sell art to investors to fund their operations. There is a risk that the direction of democratizing art could actually be constrained by socio-economic trends. Public museums provide direct access for a wide audience to be exposed to art and historical culture. As more art becomes privately held, there will be choices to be made by investors about promoting art, education and culture to the public.
Art encompasses a broad categorization of items including paintings, sculpture, jewelry, cars, furniture, wine, and collectibles. Collectors may choose to separate art from their financial assets because they regard it as a personal interest. Additionally, the historical opacity and inaccessibility of the art market may also have contributed to regarding art personally rather than as an investment. Increased public access to the art business shown by increased opportunity to engage in the art market, real time availability of pricing information, and broadened exposure to art knowledge has alleviated this lack of transparency. “It is because of this increased transparency that a collector should carefully consider the role of art on a balance sheet in addition to the salient implications of owning art.” As a result, there are a number of factors to consider that affect the valuation, risk, and estate and tax planning strategies for Family Offices with art portfolios.
Rise of Democratization in Art
The art market has evolved and expanded primarily from the patron system, auction houses and galleries pre-20th century to encompass art fairs and online providers in the 20th and 21st centuries. Auction houses such as Christie’s founded in l766 by James Christie, and Sotheby’s, itself a publicly traded company and founded in 1744 by Samuel Baker, are open to the public. Sales become public record and part of provenance. Through private sales at auction houses or through dealers/gallerists, collectors can maintain more confidentiality. Dealers and galleries play a significant role in brokering artwork on behalf of artists, collectors or estates, promoting new artists and educating the public. Artists now have at their disposal technology platforms such as Instagram to promote their work and build direct relationships with buyers. Online technology platforms such as Artsy have made art more accessible and affordable to the public. Increased market pricing information is available through internet sources such as Artnet.com, Artprice.com and Askart.com as well as industry surveys including Art Basel’s “The Art Market Report” or The European Fine Art Foundation’s (TEFAF) “Art Market Report.”
Implications for Art Valuation
Notwithstanding these trends, the art market is still an enigma. “Family Offices must use the expertise of internal and external teams to assess economic conditions, financial and art market dynamics and other variables that may influence the price, activity, availability of supply and future attractiveness of opportunities identified for investment. These opportunities are generated by the underlying dynamic of the art market, which is inefficient and illiquid, lacks price transparency and has highly differentiated products. Similar to private equity, a family office must not only engage in the right transaction at the right time and at the right price but also must enhance the value of each artwork through a variety of curatorial and marketing practices commonly practiced by successful collectors.
Since the art market is ever changing, and unexpected life events such as death or divorce can occur, it is best to be prepared and thereby avert any additional stress being placed on the family.
Such trigger events cause valuation to be examined for:
- Income tax purposes if the art is transferred during life to a charitable beneficiary
- Gift tax purposes if the art is transferred during life to a non-charitable beneficiary
- Estate tax purposes if the art is owned at death
- Insurance purposes if the art is maintained during life
In addition, families should have candid conversations about whether they share the same passion for art acquired by the collector. Having this discussion sooner will help them make the right strategic planning decisions to protect or maximize valuation and related tax consequences. Families may not be ready to make decisions on art due to other business or personal priorities. At a minimum, a general disposition in the will provides flexibility and direction from the collector as to where and with whom the collection would reside. It is highly recommended that a succession plan be developed, which involves establishing legal structures to own and retain the art.
Taking an annual physical inventory of art and keeping insurance records current are best practices, which are highly recommended. Fair market valuations are required for tax purposes whereas replacement value (or retail value) is required for insurance purposes. Therefore, independent art appraisers should be involved with the valuation process.
Using Art as Collateral for Borrowing
Loans on secured art may provide flexibility and liquidity to pay gift or estate taxes, satisfy unexpected cash needs, or avoid significant transaction costs and taxes associated with the sale of art. Specifically:
- Long-term federal capital gains tax on art is 28% vs. 20% for financial securities
- State and local taxes can result in total taxes of 40% or more on the gain
- Commissions can range up to 20% of the value of items sold
- Art sold in an unstable economic environment would result in less cash proceeds
Using art as collateral for borrowing, rather than selling the art, allows the collector to retain ownership of the art for enjoyment purposes as well as retaining the potential future appreciation of value. Finally, borrowing assists in avoiding a potential public sale thus preserving confidentially.”
Art Stewardship and Legal Considerations
How to own art is important both for practical reasons and in preventing emotional distress within the family upon the collector’s death. Establishing a succession plan requires advisers to determine appropriate legal structures to own the art and devise a mechanism for funding taxes upon death.
Use of an art LLC is a common legal structure that allows the collector to simply transfer ownership of a collection to an LLC. The LLC owns the art, and the collector owns the LLC. Family members may receive an interest in the LLC to alleviate being concerned about the exact designation of pieces of art to the family members. “The LLC becomes its own planning currency and allows the management of the collection to be separate from the underlying ownership.” Other benefits include the ability to:
- legally safeguard the asset and collector, especially in transporting pieces globally
- move value in a collection through shares in an LLC
- maintain ownership privacy
Trust structures may be established for significant gifts of art or LLC interests. There can be trade-offs to the financial and tax benefits received since owning art in a trust differs from the experience of owning art outright. Art held in trust may be required to be stored away and not available to be enjoyed personally by the collector or trust beneficiaries or even be loaned to museums.
Connect with Mary on LinkedIn: linkedin.com/in/maryeklein
About Family Office Association:
Family Office Association is a global community of ultra-high net worth families and their single family offices. It is committed to creating value for each family that we serve; value that grows wealth, strengthens legacy and unites multiple generations by speaking to shared interests and passions.
About the author:
Mary Elizabeth Klein is a Family Office and Private Equity Executive providing sustainable solutions for businesses. Mary has extensive experience in building profitable businesses and developing relationships through strategic operational and tax execution and technological improvements. She is passionate about positioning organizations to emerge successfully through change by establishing structure and a foundation to stabilize them and expand their platform for growth.