How to Affirm Your Art Investor Tax Status with the IRS
This article complements our previous article entitled How the IRS Taxes Art-Related Activities which we encourage you to read before perusing the following.
As a rule, the IRS is not disposed to accept your claim that you are an art "investor" and not a "collector" since art investors are entitled to more favorable tax treatment than those who buy art for their enjoyment. Art investors are principally motivated to make a profit from the sale of their collection. The following recaps our previous article in this regard, How the IRS Taxes Art-Related Activities.
An "art investor" is someone who buys and sells art primarily for a profit and not for personal pleasure as would a collector/hobbyist and not for earning ordinary income as would an art dealer. To qualify as an "art investor," the profit objective must be of "first importance. Unlike collectors, art investors may add to the basis of a purchased work of art their expenses such as insurance, shipping, expert consultations, art subscriptions, travel to exhibitions and galleries. Instead of being required to pay tax at the ordinary income rate up to 37% of AGI, the investor pays just 28% on the net gain as long as the work of art was held for at least one year. Unlike a collector, an investor may deduct losses on the sale of his art against ordinary income.
Both art dealers and art investors are primarily motivated to make a profit, but they are taxed differently. So, one might ask, "How does the IRS differentiate them?" Factors considered in determining whether the purchase and sale of art is done pursuant to a trade or business in the pursuit of ordinary income include:
For what purpose was the art acquired? In other words, was it for a quick resale to an end consumer (dealer's purpose) or to hold over a period of time and reap the harvest of appreciated value (as would and investor)?
The frequency of sales. Dealers try to turn over inventory quickly, unlike investors who hold artwork over long periods to benefit from appreciation.
The immediate use of the sale proceeds. Dealers are more likely to reinvest sale proceeds immediately in new inventory for sale, whereas investors are more likely to be more patient and wait a more extended period required to find the right work in which to invest.
The business of the taxpayer. Investors tend to be engaged primarily in other businesses or professions, whereas art dealers are primarily engaged in the purchase and sale of art.
The time and effort spent by the tax collector to solicit purchasers and advertise. Dealers spend a substantial time in these pursuits while investors typically do not.
Obviously, "art collectors" prefer to be treated as "investors" by the IRS since investors may deduct expenses by adding them to the basis of their artwork and may deduct losses on the sale of their art against ordinary income. However, the IRS has been traditionally loath to uphold a taxpayer's claim that he is an investor and not just a collector. Time and time again, the IRS and tax courts have found that the taxpayer's true, primary objective in collecting art is to derive personal pleasure and satisfaction from his collection and that making a profit is not of "first importance".
So, how do you prove to the IRS or a tax court that you are an art investor and not just a collector? In a nutshell, you must demonstrate that you operate your investment activities in a business-like manner. Proving that you conduct your art investment activities as a business include the following factors:
First and foremost, you must demonstrate that you seek professional advice from an art advisor to educate yourself about (a) art movements that are appreciating or depreciating, (b) artists whose works demonstrate an upward-trajectory in value; (c) undervalued artwork that is likely to increase in value, (d) written evaluation of market trends with regard to art collecting in general; (e) the most propitious time to purchase or dispose of specific pieces of art and (f) comparable values of works by different artists. The IRS knows that the vast majority of taxpayers who buy art for investments are engaged full-time in highly remunerative non-art activities. Keeping track of trends, spikes and dips in the market is highly complicated and time-consuming, and tax courts know that only full-time professional art advisors have the time and resources to be adequately educated about a myriad of economic trends in the art market. Professional art advisors typically pay many thousands of dollars per year subscribing to auction databases, attending relevant art fairs, biennials, museums/gallery openings, as well as purchasing written publications. Investors, who the IRS knows almost always are fully engaged in other highly-compensated businesses or professions, do not have the time to be adequately educated to evaluate trends in specific art movements and artists. Engaging professional art advisors to identify market trends and produce written reports to investors is vital to prove to the IRS or a tax court that you are a profit-motivated investor and not just a collector.
Unlike collectors who purchase a painting simply because they like it or because it matches their decor, real investors do not purchase or sell art without fully understanding a work’s fair market value. Hiring professional fine art appraisers to produce formal, written reports when you purchase or sell your art is critically important to convince the IRS or tax court that you are a profit-motivated art investor and not just an aesthetics-motivated art collector. Just as importantly, true art investors regularly retain fine art appraisers throughout the duration of their holdings to help them to determine whether he should sell or hold onto a steadily appreciating work of art.
True art investors, unlike collectors, typically make acquisitions regardless of their aesthetic sensibilities. Tax judges know that investors will eagerly purchase paintings or sculptures that run against their aesthetic sensibilities because their primary motivation is making money by holding onto a piece and selling it like any other commodity. Correspondence to your professional art advisor memorializing your interest in purchasing a piece notwithstanding your personal dislike for its subject or style is, for example, one way to demonstrate that you are a profit-motivated investor instead of a collector.
Keeping your art investments in your home for the entire duration of your ownership usually evidences that you collect art for your personal enjoyment and not for making a profit. This is a serious mistake if you want to take advantage of the highly favorable tax treatment to which art investors are entitled. Serious art investors display their works in art galleries, participate in art exhibitions, and lend important works to museums to generate excitement among art collectors, to improve a work's provenance.
Keeping and organizing business-like records for your collection goes a long way to prove that you are an art investor and not just a collector. Organizing receipts of not just the purchase of the piece itself, but also of your cost in procuring the advice of professional fine art consultants, art appraisers, art magazine subscriptions, travel costs to galleries and exhibitions, and insurance premiums show that you have kept track of your deductions as would any bona fide investor. Organized expense ledgers and even contemporaneously-written diaries memorializing your decision-making process in purchasing or disposing of your art are also important to prove your profit-motivation. Also, keeping and protecting documents, photographs, previous auction catalogues, purchase receipts, letters or any other document or thing evidencing your piece's provenance is critical to convince a judge that you are treating your art work as an investment and not just for recreational use.
Real art investors purchase insurance to protect their investments in the event of the theft or damage to a piece. Periodically retaining the services of a professional art appraiser to update written appraisal reports for your collection is also extremely important to demonstrate you’re seriousness in protecting your investment. If, for example, your piece quadruples in value over time and then it is stolen, insurers will only compensate you for its value at the time of procuring the insurance and not the four-fold increase in value. No serious art investor would fail to periodically obtain updated written appraisal reports for the purpose of increasing the amount of your insurer's indemnification in the event of theft or damage of his appreciating art.
Your history of success in converting your art purchases for a profit is good evidence that you are an investor and not just a collector. However, showing a series of small profits from your sales tends to show that you are a collector instead of an investor.
Comingling money you receive from the purchase and sale of your art tends to demonstrate that you are merely a collector, not an investor. Serious investors usually form sub-s corporations (or more typically) limited liability companies to act as the legal owner of the art. This is important because limited liability companies formed for the purpose of art investments are required to have separate bank accounts as well as separate records regarding the purchase, sale, and incidental expense related to art acquisitions and sales.
Devoting and memorializing in writing the substantial amount of time that you devote to your art purchase and sales is also good evidence that you are an art investor.
None of these factors are absolutely essential to prove that you are an art investor instead of a collector except to state that some factors, such as hiring art consultants and appraisers are more critical than others.
 Treas. Reg § 1.212-1(c).
 Presumably, many of such deductible expenses would have to be pro-rated among inventory.
 I.R.C. § 1(h)(2)(4)(A)(i).
 IRC § 1(h)(2)(4)(A)(i).
This article is written for informational purposes only. Please consult your agents (accountants, attorneys, wealth managers, etc.).