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Thursday, August 31, 2006


Owners of valuable art often like to enjoy their artwork at home, while still obtaining a charitable deduction for the art. One way that they have been able to do this was to gift a fractional interest in the art to a charity, while also retaining a fractional interest. If they did things right, they could get a deduction and keep the art for part of the year. The charity also had possession of the art for part of the year, although there is even law to the effect that the charity did not even have to take possession of the art - its legal right to do so would be enough to justify the deduction.

This situation was perceived as an abuse by Congress, and new limits on this technique were enacted as part of the Pension Protection Act of 2006. More particularly, the new provisions require that if a fractional interest is gifted to charity and a charitable deduction is desired, the donor must transfer to the charity all of his or her remaining interests by the earlier of (a) 10 years from the initial transfer, and (b) his or her death. Thus, the donor can no longer retain a fractional interest ownership indefinitely, but must eventually transfer his or her remaining ownership interest to the charity. Further, the new provisions require that the charity obtain substantial physical possession of the property and use the property in a use which is related to its exempt purpose.
If these new restrictions are violated, the tax savings from the prior fractional charitable gifts (plus interest on the tax) are "recaptured" and thus made be paid to the IRS by the donor. Further, a penalty of 10% of the recaptured tax is imposed.

The bigger problem is not with these restrictions - it is with the deduction for the gifts of fractional interests to charity after the first gift. The provisions indicate that the deduction for income, estate, and gift tax purposes for the subsequent fractional transfers is limited to the appropriate fractional portion of THE LOWER OF the fair market value of the gifted property (a) at the time of the initial gift, or (b) at the time of the current gift.

Therefore, if the artwork goes up in value after the first fractional gift, when the subsequent factional gifts are made (and assuming that a fair market value deduction is otherwise allowable), a full deduction will not be available. This means that for a gift during lifetime a full income tax deduction for the current value will not be available, and a taxable gift will result for the appreciation in value of the gifted portion from the time of the initial gift to the current gift (although in reading the statute there may be a way to read it to avoid such a taxable gift). Similarly, if the remaining fractional interest of the donor is transferred to charity at death, the appreciation that occurred can result in estate tax since the estate tax charitable deduction will not be as high as the gross estate inclusion value for the fractional interest.

Due to this valuation rule, fractional gifts of artwork are likely to be substantially diminished.

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