How owners of paintings and other collectible objects can keep the art and cut their taxes

By Daniel Grant

A common estate-planning tool, the irrevocable trust, is increasingly being used for an uncommon purpose: It allows art owners to reap tax savings by transferring ownership of their paintings or other collectible objects, but keep possession so they can still enjoy them.

First, the tax savings. Property placed in an irrevocable trust, in this case the art, no longer is legally part of an estate, which reduces the value of the estate for tax purposes.

But the tax benefits potentially go far beyond removing the art’s current value from the estate. The art, which legally is gifted to the trust, will be appraised for tax purposes at the time of the gift. The amount of the appraised value above the $14,000 annual exemption from gift taxes will be deducted from the owner’s lifetime combined federal gift-tax and estate-tax exemption (currently $5.45 million). Or if that exemption has already been used up, the owner will pay tax on the gift. But in either case, if the owner holds on to the art instead, there is a chance it will be appraised at a much higher amount when he or she dies, resulting in a much bigger tax liability for the estate.

“Basically, you are sheltering the appreciation,” says Michael Kosnitzky, a partner in charge of the tax and middle market practice group at the law firm of Boies, Schiller & Flexner. The cost of setting up a trust varies, generally not exceeding $15,000, depending on the trust’s complexity and the jurisdiction of the trust, but the potential tax savings outweigh the setup costs, Mr. Kosnitzky says.

Renting Renoir

The trust will take responsibility for storage and care of the art, with money provided by the benefactor to cover the cost. But what if you don’t want to give up your art? You don’t have to.

“With art prices increasing, there is interest in the idea of putting your art in a trust to shelter the appreciation, and then renting it back, so that you can hang it on your walls,” says Diana Wierbicki, partner and global head of art law at the law firm Withers Bergman. “People say, you can do it with a house, why not with art?” (People more commonly place their home in an irrevocable trust and then continue to live in the home and pay market-value rent to the trust.)

One complication is that determining a fair-market rent is much more difficult for art than it is for real estate, because the market is so much more limited. The rent matters a lot to the Internal Revenue Service, which might disallow a trust if auditors conclude that the trust isn’t being paid enough. “You have to look at the optics,” says Tim Bresnahan, vice president in the wealth-planning advisory services group at Chicago-based Northern Trust. “If a collector puts artwork in a trust and then leases it back for a dollar, that would be a clear violation of trustee duties and responsibilities.”

The problem for taxpayers, Ms. Wierbicki says, is that the IRS has “not provided a safe-harbor methodology”—it hasn’t set the rules—for determining fair market value of art rentals.

So what should an art owner do? Mr. Kosnitzky recommends hiring an art leasing firm to set a rental price. Joshua Ginsberg, owner and chief executive of Chicago Art Leasing, which rents artwork by emerging contemporary artists to Chicago-area businesses, says his company’s monthly leases tend to range from 5% to 7% of the retail price of a work of art. At New York City-based Artemus, which leases artworks to corporations and individuals, the monthly rental fee is between 6% and 12% of the appraised value, according to the company’s chief operating officer, Cedric Autet. The lower-percentage rental fees are generally for more highly valued works—done by established artists and in good condition—to make the absolute amount of those fees more affordable.

The heirs’ side

What do the beneficiaries of a trust get out of all this? Property, such as art, that has been placed in trust for one’s children or anyone else doesn’t belong to the beneficiary or beneficiaries but rather is owned by the trust. The children, say, may enjoy the art but can’t sell it—only the trust can do that.

Eventually, of course, the heirs may come to own the artwork, either upon the benefactor’s death or at a later time designated by the benefactor in the terms of the trust. The art may remain in trust as long as permissible under state law (usually, the life of the benefactor plus 21 years, though in some cases it may be longer). Another possibility is that the terms of the trust dictate that the art be sold and the proceeds be given to the beneficiaries.

“Assuming that heirs eventually do gain ownership of the art, if they were to sell objects from that trust, they would pay capital-gains taxes at the appreciated value, not at the lower value when the trust was first created,” Mr. Kosnitzky says. If the trust sells the art, it would pay the same taxes. The taxable amount would be the difference between the value at the time of the sale and the “tax basis,” which generally is the amount paid for the art by the donor, Mr. Kosnitzky says.

Mr. Grant is a writer in Amherst, Mass. He can be reached at reports@wsj.com.

Originally published in Wall Street Journal