No more partial interests in art?

The Pension Protection Act of 2006 resembles Forest Gump's box of chocolates, it's so full of surprises. Here's one that affects art collectors.

It's long been the case that collectors can't take an immediate tax deduction for giving a remainder interest in their art collections to charity while they retain life estates. One alternative is to split the interest in the collection vertically instead of horizontally, using a time-sharing model. For example, a collector might donate a 1/3 fractional interest in a valuable painting to a museum, giving the museum the absolute right to display the painting for 4 months per year. If a donor spends part of the year living apart from his collection anyway, this can be an ideal solution. A current income tax deduction was allowed for fractional interest--if the painting is worth $3 million, the deduction would be $1 million for a 1/3 inerest.

Two provisions of the new law may kill this strategy.

First, no deduction will be allowed unless 100% ownerships vests within ten years, or at the death of the owner if earlier. If the complete transfer of ownership does not materialize as promised, all tax benefits are recaptured and a 10% penalty is imposed. Also, a prior Tax Court decision that allowed the deduction for the legal right to use the painting, as opposed to the actual use of the painting for a portion of the year, has been overturned. The museum must at least take possession of the painting.

Second, when the additional fractional interests are eventually given away, the charitable deduction will be limited to lesser of fair market value or a fraction of the value of the initial contribution. In other words, the remaining fraction can't apply to any appreciation.

An example should make that more vivid. Say that a 1/3 interest in a $3 million painting is given to a museum in year 1, and that at the owner's death in year 9 the painting has doubled in value (that's only 8% per year, after all). The 2/3 value included in the estate is $4 million. but the charitable deduction for the estate is limited to $2 million. Estate tax will be owed on the remaining $2 million, even though that also is passing to the charity.

This is an unfortunate result for museums who want to lock in future accessations today. I've already seen plans for buying more life insurance to deal with the problem. As if we didn't already know who killed estate tax reform?