WASHINGTON — An interesting situation arose recently with a colleague of mine.
Acting as the executor of a longtime client’s estate, she discovered an original statue of a famous 19th century artist in the recently deceased client’s closet. If no pre-emptive planning was done, this statue could pose several potential issues for the estate and their heirs.
While we may not find artwork of this caliber stashed in the closet of a relative, we or our family members may be collectors of art and other valuable items that we consider not just as personal property that reflects our passions, but also as a means of building our net worth.
In fact, in a 2017 report, Deloitte found more than 80 percent of collectors reported they thought of their art collections as a type of investment.
Why then do many high-net-worth collectors fail to adequately plan for the ultimate distribution of these potentially valuable assets?
If you own valuable artwork, antiques or other collectibles, then you may want to consider how to correctly distribute these assets upon your death.
To help you and your heirs plan for these treasures when you are gone, we have touched on a few important topics to consider.
What is a collectible?
According to the IRS, the definition of collectibles includes works of art, rugs, antiques, any metal or gem (with exceptions), any stamp or coin (with exceptions), valuable alcoholic beverages or “any other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m)”.
In general, there are two ways you can distribute collectible personal property — either leave the assets to your heirs or donate them to a charitable organization.
In either case, special tax and estate laws will apply and these laws differ from laws governing distribution of other types of assets in an estate. Ignoring these laws can result in unnecessarily high capital gains taxes to your heirs, income or estate tax penalties, or depreciation of the asset’s market value.
Equally troubling are issues that may arise from ownership disputes or difficulty in liquidating rare items, assets with limited market demand or collectibles where their worth is derived primarily from family sentimental value.
For now, we will address special considerations for distributing collectible personal property to your friends or family members.
Why is proper valuation important?
Many estate plans clearly articulate a plan for division of financial assets but fail to address distribution of more complicated assets that often have both financial and sentimental value. Jewelry, large coin or stamp collections and rare antiques are just a few examples of assets that can complicate an otherwise orderly distribution of someone’s estate.
In many families, members often have different opinions about fair market value for collectible assets left behind. These differences can lead to delays in the settlement of an estate which could be costly, fuel disagreement among heirs, or even lead to litigation.
One way to reduce the chance of this occurring is to obtain appraisals for all valuable collectibles while you are still living.
Some attorneys and CPAs also suggest in your estate planning documents you include the names of at least two dealers and one or two auction houses who specialize in your type of collectible. This information can be helpful to whoever settles your estate, especially if they are not an expert in things like wine or antique needlepoint.
Markets and the economy certainly influence a collection’s ultimate value. It’s best to get estimates from multiple sources with dates and valuation amounts to help your executor and heirs have a sense of a reasonable range of values for the collection should they decide to sell the assets.
By providing clear documentation of the potential value of your precious belongings in your estate documents, you reduce the chance that something having great value will be sold at a deep discount by a naive heir or donated away to charity by an unaware executor.
Proper valuation is also important to help establish how much should be included in the calculation of the overall value of your estate.
Delays can occur if someone must take extra time to find the right experts rather than simply contacting the experts you provided for your type of asset. Since there are no licensing requirements for appraisers of personal tangible assets, whoever selects the appraiser will need to carefully consider their credentials or level of expertise in a particular area.
Remember that even if your heirs choose to hold the assets rather than sell them, they will still need a value of all assets to establish the total value of your estate.
Tax laws also stipulate that if assets are not sold within a period of time of the owner’s death, or if values exceed a certain level, the estate must obtain an official appraisal for valuation purposes. Some estates try to avoid this requirement by donating assets directly to a charity, but this is technically not allowed unless the estate plan specifically authorizes such assets to be donated rather than passed on to estate beneficiaries. And failing to report some valuation for tangible personal property on the estate’s Schedule F (Form 706) is a leading audit trigger for the IRS.
Note that valuation for insurance purposes is not the same as valuation for estate planning and legacy purposes.
Insurance appraisals and valuations for determining coverage are meant to reflect replacement or retail value of collectible assets and typically result in the highest appraised value, which often differs substantially from fair market value.
If you think valuation for insurance purposes may cause confusion about the value of assets if you pass away, you’ll want to leave special instructions so that heirs don’t assume insurance schedules are accurate as to correct valuation.
Related, an absence of insurance could imply lack of total fair market value to an uneducated estate settlement team.
How are collectibles taxed?
Reliable valuation from expert appraisers is also necessary to satisfy income and estate tax laws.
An appraisal done as of the date of death provides an accurate tax basis that the beneficiary takes on as their own basis when the asset is passed to them. This is an important figure as it ultimately determines the taxable gain and amount of income tax inheritors will pay if they hold any of the assets for a period of time then sell them at a later date.
This special tax law, known as “stepped-up basis”, may provide some incentive for you to keep highly appreciated assets until you die as a way to reduce the overall capital gains tax that you or your heirs would have to pay.
On the other hand, you’ll need to consider whether keeping the asset would increase your estate valuation to a level that triggers unwanted estate tax liability.
Basis amounts also work in reverse, meaning there could actually be a reduction or “step down” in tax basis if the value of the asset at the time of inheritance is lower than the original price paid.
We’re finding devaluation is increasingly common as the millennial generation is not as interested in purchasing antique furnishings. A millennial generation with more frequent relocation, less time to maintain assets (think polishing silver) and smaller home sizes contributes to declining market values for collectibles being handed down today.
When collectible assets are held for at least one year by an investor (i.e., a beneficiary who is not acting as a dealer in that type of asset), then long-term capital gains tax rates apply.
One important fact is that federal long-term capital gains rates on collectibles are higher — a whopping 28 percent — no matter the level of your adjusted gross income (unless you also owe the 3.8 percent surtax). That compares to a top long-term capital gains tax rate of 20 percent (23.8 percent with surtax) on other types of assets.
Another disadvantage, especially for higher income beneficiaries, is that sale of collectibles held less than one year are taxed at personal income tax rates. If you inherit a collectible and later sell it at a loss (compared to the basis you receive), your ability to write off such loss will depend on whether there is any evidence of “personal use.”
For example, if you inherit a valuable piece of artwork, hang it in your home then sell it at a loss, the IRS may reduce or eliminate the amount of loss you can deduct on your income taxes. If a collectible is held strictly for investment purposes, then you can usually deduct the loss. A CPA or estate tax attorney can help you determine if inherited collectibles are likely to be treated as personal use or investment property.
Depending on the asset value and/or state laws, estate tax also may apply to collectible assets passed after death. In many cases, reporting requirements hinge on either asset value, total estate value, or both.
Attorneys are quick to point out that there is no statute of limitations for estate tax fraud, so regulators can hold someone liable for tax audits or penalties indefinitely. There are plenty of real world examples of heirs owing taxes or penalties and estates forcing an asset sale that ultimately erodes market value and reduces the total amount inherited by beneficiaries.
What should I do to prepare?
There’s no way to guarantee smooth disposition of your collectibles and personal property. Market value, demand, and family dynamics change over time.
There are numerous planning alternatives that can lessen the estate tax burden imposed on collectibles.
Here are eight planning techniques you can initiate while you’re alive to improve settlement of these assets upon your death:
- Obtain one or more appraisals from certified experts. You may also want to request a certificate of authenticity for high value and rare items.
- Keep records of purchase date, price, appraisals, damages, insurance coverages and cost of any improvements such as refurbishment or repairs. For collections, consider making a list of all the individual items in the collection and record the above information for each piece in the collection. You may also want to include selling dates for items of a collection and the names of past buyers and sellers as they may serve as a ready market for the collection.
- Talk to your heirs and ask which items are most important to them. That will give you an idea of potential disagreements about the inheritance of particular items. Make sure any promises to pass down certain items to a particular person are clearly written in your estate plan.
- Consider ways to equalize inheritance amounts and ways to respond to potential claims of fairness that may arise among your beneficiaries. It’s tempting to leave this difficult task to your chosen executor, but that person could have a conflict of interest, especially if they are your spouse or a benefiting adult child.
- Consider taking advantage of annual or lifetime gift exclusions by gifting personal property during your lifetime.
- Articulate in your estate documents who will bear the cost of storing or shipping items, especially if intended heirs reside out of state. With more inheritors living farther away, it’s increasingly common to include language stipulating that an estate will bear the cost of storage during estate settlement. Consider whether beneficiaries have the means to cover what could be expensive delivery of larger or fragile items they stand to inherit.
- Understand potential benefits of gifting to charity, keeping in mind regulations and confirming that the receiving charity can handle the management and sale of the donation. Donor Advised Funds may be a useful tool for gifting collectibles, depending on the fund sponsor. To learn more, read: Are donor advised funds right for your charitable giving?
- Notify your investment adviser, CPA and estate planning attorney of collectibles that may have value. You may also wish to have a discussion with your executor to make them aware of the special nature of this personal property and to alert them to arrangements you’ve made to preserve the asset value or to respond to potential family disputes.
Becoming aware of the unique laws that pertain to valuable artwork and other collectibles can help ensure an orderly distribution of your treasured collectibles.
Taking a few simple steps now can help maximize value to your beneficiaries by minimizing taxes, and perhaps most importantly, reducing family disputes.
Dawn Doebler, CPA, CFP®, CDFA® is a senior wealth adviser at The Colony Group. She is also a co-founder of Her Wealth®.
