Michael S. Schwartz, CFP®, AEP®
Pooled Income Funds are a powerful and often underutilized financial tool.
Going once, going twice, gone – literally. It’s not the way rare art auctions are intended to culminate,but then again, investments rarely end as anticipated. However, as far as investment risk goes, what occurred on Oct. 5, 2018, took it to an entirely new level. Banksy’s Girl with Balloon had just sold for about $1.4 million – more than three times the pre-auction estimates. But the moment the auctioneer dropped the gavel, the famous painting began dropping from the bottom of the frame – in shreds. The secretive street artist placed a hidden shredder inside the frame, which was apparently remote-controlled by an accomplice in the audience. Banksy later admitted the prank didn’t go as planned, and the entire painting was supposed to form a pile of paper mulch on the floor. In an anonymous online video, he showed his rehearsals of how it was supposed to work and ended the video with the caption, “In practice, it worked every time.” So, while investments rarely go as planned, apparently neither do pranks. With only half the artwork dangling from the bottom, he changed the work’s name to Love is in the Bin. While the stunt seemed like an act of estruction, the art world immediately started speculating that the value had more than doubled. “That’s the ironic part about it,” commented Leon Benrimon, Director of Modern and Contemporary Art at Heritage Auctions. “It was meant to be a criticism of the art market, and I think it’s going to double the value of the work.” Benrimon added, “You’d almost wonder if he’d recognize the fact that it could’ve doubled the value of the work.”
There is, however, another kind of shredder that never increases your investment’s value – taxes. In our last article, Imagine Art Collecting Without the Taxes (Fall 2018), we showed how the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated like-kind exchanges for art collectors but pointed out that there are other ways to shield your investments. Various charitable and non-charitable planning methods are still available for art collectors. This article will serve as the first in a series that will outline ways that investors can strategically dispose of capital assets while reducing, eliminating, and/or deferring capital gains taxes. It’s the art of shredding taxes.
Inside the Frame:
Pooled Income Funds
A powerful and often underutilized tool in financial planning is the “young” Pooled Income Fund (PIF), which is a charitable trust. The trust is controlled by a charity and donors contribute assets, which are generally cash, stocks, mutual funds – even art and collectibles. A “young” pooled income fund is one that is less than three calendar years old. One must understand that all donations are irrevocable when using a planned giving vehicle such as a PIF. The majority of PIFs in the marketplace have many restrictions and are charity-friendly. There are, however, a few donor-friendly PIFs that are flexible and willing to accept illiquid assets such as art and collectibles. Illiquid assets are usually sold, and the proceeds are reinvested into managed portfolios comprised of marketable securities. In the common PIF structure, the charity commingles the assets from various donors, who receive an annual payment proportional to their interest in the fund.
Donors receive payments for life and may also designate payments for the lives of one or more people, or a named class of living beneficiaries. A donor advised fund can also be named as a beneficiary. A longer income benefit period (more than one life) reduces the charitable deduction.
Upon death of the final income beneficiary, the remainder interest is transferred to the charity. Donors will not usually recognize a gain or loss on the transferred property. Instead, the cost basis and holding period are transferred to the fund. PIFs therefore may be ideal for anyone who wants to dispose of a highly appreciated, non-income producing asset in exchange for a lifetime
income stream for the benefit of one or more generations. Compared to other charitable planning vehicles, “young” PIFs provide sizable charitable income tax deductions. For instance, a 55-year-old donating cash to a single life PIF provides the donor with a charitable deduction equal to 70.8 percent. In contrast, a 55-year-old donating cash to a joint life PIF (spouse 50 years old) provides the donor with a charitable deduction equal to 62.5 percent. The charitable income tax deduction is equal to the present value of the remainder interest that passes to the charity. Depending on
the donated property, the deduction is limited to anywhere from 30 percent to as high as 60 percent (cash donation) of the donor’s adjusted gross income (AGI). Any deductions not fully utilized in the year of the donation carry forward and can be used to offset future income tax for up to five additional years.
Benefits of a PIF
Donating art, antiques and other collectible objects to qualified organizations through a PIF may provide you with the following benefits:
◗ No gain or loss on transferred property;
◗ An immediate tax deduction not affected by the alternative minimum tax (AMT);
◗ Avoidance of capital gains tax on the sale of appreciated assets;
◗ An estate and gift tax deduction;
◗ Remainder interest is not included in the taxpayer’s taxable estate; and/or
◗ A lasting legacy to the charity or charities of the donor’s choosing.
To illustrate the economics of donating highly appreciated art to a PIF, assume that Banksy’s Love is in the Bin is now worth $2 million, the cost basis is $200,000, the new buyer is 55 years old, is married with a same-age spouse, both are U.S. citizens and they each have 30 years to life expectancy. Following the purchase, the buyer decides to donate the artwork to a newly created PIF setup for the benefit of the donor, the donor’s spouse and their two children (ages 24 and 21). Once donated, the artwork is resold for cash and the net sales proceeds are reinvested in a diversified portfolio of marketable securities. For our illustration, we will assume that there are no costs associated with the sale. By donating the artwork directly and not for a related use, it will limit the charitable income tax deduction to $200,000 and up to 50 percent of AGI. Art is considered tangible personal property which, unfortunately, without additional financial planning, limits the charitable deduction to its cost basis.
Assuming a return of 6 percent (3 percent growth and 3 percent income), the plan would provide the following profound benefits over their lifetime:
- Income tax savings of $100,000 for a donor in a 50 percent tax bracket;
- ~$2,039,436 of income to the donor and spouse;
- ~$2,977,401 of income to the children; and
- ~$7,109,500 to a charity or charities.
The results can be further enhanced incorporating the donation of cash and/or properly structured life insurance. Like all tax-advantaged strategies, there are multiple points to consider and each case depends on the specific set of circumstances. It is important to re-emphasize, not all PIFs are created equal. A properly designed and administered donor-friendly PIF can create significant capital gains tax savings and be used to effectively offset non-transaction related taxable income. The associated charitable deduction may be used to average down the tax cost of other taxable capital asset dispositions. The beauty of a PIF is that you can strategically gift your assets for the future benefit of causes you believe in, but you don’t lose the economic power of the
donated gifts during your lifetime. In the world of art and collectibles, the possibilities are endless, and there is no best answer – just one that’s best for you. If you are in the market
to sell, seek out a qualified financial planning firm who can help you tailor a better outcome, one where taxes won’t leave your investment dangling in shreds.