The Tax Cuts and Jobs Act of 2017, which went into effect Jan. 1, 2018, is the most comprehensive federal tax changes in a generation. The Act will have a major impact on estate tax planning going forward for personal property, which includes everything from fine art, motor cars to jewelry, rare books and manuscripts. But saving money isn’t always the No.1 priority. There are many nonmonetary factors to consider for end-of-life planning of property even for the wealthiest clients.
Most high-net-worth individuals have acquired valuable collectibles during the course of their lifetimes. This accumulated tangible personal property is a reflection of their tastes, travels, generation and lives. For instance, John and Celeste Fleming, from Denver, Colo., were devoted philanthropists and patrons of Asian art. Their love of Asian art stemmed from John’s naval posting in Japan in the 1950s. Although there may not be federal estate tax on much of this property now under the Act, there are still compelling personal, legal and tax reasons to value and sell this property. There are also many HNW individuals with gross estates over the federal exemption for which the Act makes no significant difference.
Federal Estate, Gift and Generation-Skipping Transfer Tax Exemptions
The Act effectively eliminates the estate and gift tax for most taxpayers by doubling the amount of individual exemptions up to $11.2 million for individuals and $22.4 million for married couples. The new exemption will increase by indexing inflation annually. As of the end of 2017, only 0.2 percent of all estates were subject to estate tax. In 2018, this rate will be an even smaller percentage. All estates with total assets above the new exemption threshold (not using portability between spouses) will pay the 40 percent federal estate tax rate. The doubled exemptions will expire in eight years on Dec. 31, 2025, at which time the exemptions will revert back to the 2017 $5.49 million per individual level adjusted for inflation.
Income Tax Basis Step-Up at Death
Despite doubling the exemption levels, the step-up tax treatment is unchanged. A decedent’s heirs continue to receive a step-up in basis for all assets bequeathed or gifted by decedents including tangible personal property. The step-up in basis is the fair market value as of the date of the decedent’s death. For instance, if the decedent owned a Porsche 1973 911 RS 2.7 M472 that was part of his taxable estate that he purchased 15 years ago for $40,000, and the car is worth $500,000 at the date of his death, his heirs would receive a step-up in basis of $500,000. When selling in the future this inherited property, the beneficiary will owe tax on the difference between the sales price of the inherited property and the step-up in basis. The heirs of the inherited Porsche would pay the net capital gains tax of 28 percent of any sales price above $500,000. Assuming a $570,000 sales price, they would owe capital gains tax on $70,000.
Inter vivos gifts will continue to pass to the donee with the donor’s tax cost. In the Porsche example, the donee would receive a $40,000 tax basis. The donee will pay tax on unrealized gains and assuming a $570,000 sales price, capital gains tax on $530,000. Thus, for property that’s had large unrealized gains, it might make sense for donors to hold off on making inter vivos gifts so that beneficiaries obtain the after-death step-up in basis. This is less critical when there’s little change in value over time or the property was purchased recently before death. A 16th century painting by Florentine Old Master painter Michefe Tosini, which was acquired for $145,000 in 2013, and then four years later, at the time of the decedent’s death in 2017, is worth $150,000, the step-up in basis is an insignificant change. As a result, understanding the valuations of tangible personal property is important not only for income tax planning but also for estate planning and ultimately estate administration. For instance,the Act prohibits Internal Revenue Code Section 1031 “like-kind exchanges” for art. This little discussed change in the IRC, which allowed the deferral of capital gains tax, remains in place for real estate investments. Section 1031 art exchanges allowed art investors to buy and sell property without realizing capital gain (which is taxed at 28 percent) so long as the taxpayer complied with applicable Treasury Regulations and Internal Revenue Services rules, including replacement with like-kind property (e.g., oil painting for oil painting); holding the property primarily for investment or trade and business purposes; not personally handling the cash or “boot” and completing all transactions within the strict time limitations (45 days to identify property and 180 days to close). Provisions in the Act also decrease tax incentives for itemizing deductions and therefore possibly for donations of art to museums.
State Estate and Inheritance Taxes
Many states have their own estate tax. This is a dynamic area of the law, and corresponding exemptions are frequently changed. States have different laws on the exemption amount and rate of estate taxes for residents that apply in addition to any federal estate tax. Some states, such as California, have no estate tax. Other states, including Connecticut, have exemptions that are less than the federal exemption. While other states, including New York, aim to make their exemption the same as the federal exemption. And a handful of states have inheritance taxes.
Formal Fair Market Value Appraisals
Decedents with estates over the federal exemption and resident in states with applicable estate or inheritance taxes will need to value their property in a formal appraisal report outlining the FMV of tangible property for applicable federal state tax filings. The appraisal must list the date of death or alternative filing date for all of the decedent’s personal property including decedent’s silverware, china, furniture, decorative arts, jewelry, fine art and wine. For estates under the exemption limits, it may also be advisable to obtain FMV appraisals—shortly after death—for distributed property and for which those heirs will take advantage of the step-up in basis.
Whether or not the estate files an IRS 706 federal estate tax form, it’s a best practice to secure an appraisal of decedent’s property promptly after death for step-up in basis purposes. The date of death is used as the benchmark for determining FMV for estate taxes and step-up in basis. Market conditions may change dramatically over time, and it can become problematic to reverse engineer valuations later. The burden is on the taxpayer to show basis. For inter vivos gifts, this can be difficult to achieve if the family can’t locate the original bill of sale or identify when and where the decedent acquired the object.
FMV appraisals will also continue to be a helpful tool for estate planning and estate administration. Appraisals provide families with an independent means to assess the family’s cherished tangible personal property. The report can be used to identify specific bequests outlined, for instance in a trust agreement, and for general “round robin” distributions so that children receive property of equal value. For example, siblings were surprised to learn that their mother’s brooch in platinum with numerous small diamonds, emeralds and sapphires, which they believed to be worth around $85,000, was actually an extraordinary, museum-quality Art Nouveau piece by famed jeweler Georges Fouquet, and worth around $250,000.
Estate Auction Sales
Estates consign property for public auction sales for a number of reasons. The Act will eliminate the need for most estates to sell property to pay for federal estate taxes. But more often than not, the next generation has different tastes from their parents and won’t want to keep most of their parents’ property or store it indefinitely in their homes or in offsite storage facilities.
On the other hand, a favorite painting or sculpture can’t be split among quarrelling siblings. Often the fairest way to address this kind of family dispute is to sell it at auction. In one instance, heirs couldn’t agree on who got to keep a beloved Schist figure of Buddha from the ancient region of Gandhara from the 3rd to 4th century, which had a $50,000 to $80,000 auction estimate. This beloved piece had been in the family’s entrance hallway for over 50 years. As a result, the trustees decided to sell the figure at auction and split the proceeds among the heirs.
Public auction sales satisfy executors’ fiduciary duties. Of course, heirs are also welcome to bid on the coveted property too. Heirs may choose to sell inherited property soon after distribution to limit future income taxes on property, which had and may have future significant gains. Others may choose to sell their property rather than donate it because of their inability to use charitable deductions.
With all this being said, the future is uncertain. No one can predict tomorrow’s trends in the art market and future sales of estate property. The United States remains the second largest auction market (behind China) and will likely continue to be a leader in selling art and other valuable collectibles across generations. This will likely continue irrespective of the extent to which U.S. sellers face less certain short-term tax consequences.