04/26/23

How To Hoard Money In Art

the economics of art, tax advantages, selecting investible art, and more

or the better question is: how do rich people avoid taxes via art?

I want to give a disclaimer here before we get into it:
**This piece is written solely out of curiosity. I have never and do not plan to avoid paying taxes. I am just a curious art enthusiast**

The strategies below are US-centric in their specificities, but the tactics can generally apply in most countries.

There are different ways the rich skirt hundreds of millions of dollars in tax payments. A popular one is setting up foundations where there is an immediate deduction of up to 30% of your adjusted gross income (AGI). And you only have to distribute 5%, all while avoiding capital gains tax. Ever wonder why Hollywood celebrities have foundations? You think they really care about Alzeihmer’s research that much? This obviously has exceptions to the rule like Rockefeller, or Gates, or even CZI. Family foundations are used as a tool for tax implications in art. More on how wealthy families marry their philanthropic and tax mitigation strategies below.

The uber rich, the high net worth families, usually go the family office route as that requires at least $100 million in assets. They are able to deduct what would be non-deductible. They can hire their kids and pay them a hefty salary that’s expensed for the business, and usually passed on to the kids. Hello, Succession! Or the IRL Murdoch and LVMH families! Forbes did a great piece on the LVMH family – the Arnault Family Office Story. 

Alternative Investments

First, it’s important to know that art is an asset class that comes under something called “alternative investments” – investments that are not traditional like stocks, bonds, and cash. These investments tend to have less liquidity, but are also less regulated in most cases. They can offer potentially higher returns and diversification benefits. Outside of art, some alternative investments include real estate or real estate investment trusts (REITs), private equity, hedge funds, commodities (gold, oil, etc), and crypto. Alternative investments often carry higher risks and require a higher degree of expertise to manage.

Why Art

I want to talk about art though because any rich person or nepo-baby can do the above. It’s actually not too different from investing in hedge funds and private equity. But it’s an asset class that has very limited access to expertise, information, disclosure, and transparency – like venture capital and private equity used to be. 

The How: Structures to maximize investment

Art collectors want to maximize the efficiency of their investment. There are a number of different structures and strategies that can be used to purchase art in a way that creates tax advantages.

The following is not an exhaustive list, but covers a good amount of tactics.

One is done by a 1031 exchange. 

A 1031 exchange, also known as a like-kind exchange, is a tax-deferred exchange of one investment property for another of similar kind or nature. This exchange allows an investor to defer paying taxes on capital gains from the sale of a property, as long as the proceeds are reinvested in a new property. The term "like-kind" refers to the nature or character of the property, rather than its quality or condition.

In the context of art, some art collectors use 1031 exchanges to defer taxes on the proceeds from the sale of art by reinvesting the profits into new art purchases. This allows them to avoid paying capital gains tax on the sale and continue to grow their art collection without incurring immediate tax liabilities. 

Essentially, they save millions of dollars in taxes by rolling over their profits from selling their collection pieces into buying more art. This practice also allows collectors to expand their collection. As the price of high-end artwork continues to rise, collectors take advantage of this opportunity. 

Deferring taxes on art sales income through 1031 exchanges is legal, though some lawmakers disapprove. There are specific rules and regulations governing 1031 exchanges, and it's important to consult with a tax professional to determine if this strategy is appropriate for your specific situation.

Another common method to create tax advantage is the donation of artwork to a privately held family foundation. Or working with an institution where you give partial gifts and artwork annually. Essentially, you assign a percentage interest in the artwork as a promise gift. Hypothetically, if you want to shelter a million dollars of income a year and you buy a $5 million dollar painting, you can split that up over the course of time and give 20% every single year to this institution. You can control the timing of the donation and its tax implications. 

There are other “tools” like charitable lead annuity trusts, charitable lead remainder trusts, etc that really depend on the individual or the family’s unique asset portfolio. 

Another tool I want to touch on is putting a collection into a partnership or an LLC – this is often used to pass art and wealth down to heirs. Because art is in ill-liquid asset class, has a limited market, trades steeper discounts when forced into liquidation creates an opportunity to put into an LLC. You can give members of your family interest in that LLC or limited partnership. You can give it to them at a discounted value because of the limited liquidity, especially if you have to sell with short notice. Moreover, you can overlay additional discounts, because you are “gifting”, minority interests, etc. 

Lastly, and I think the coolest tactic, is when high-net-worth individuals use freeports, which are free economic zones located in or around ports of entry where artwork can be stored without being subject to customs duties or taxes, to store their expensive art acquisitions, among other high-priced investments. Freeports provide maximum security and discretion, and allow for all trading and selling to take place within the facility, ensuring anonymity and freedom from taxes. These facilities are impenetrable and feature high-tech security features, making them ideal for storing and hiding valuable assets. The oldest and largest freeport in the world is in Geneva, which is home to 1.2 million works of art. In 2018, New York City opened its own freeport, called ACRIS, in Harlem, with state-of-the-art security features.

In 2015, a major art scandal emerged involving Swiss art dealer Yves Bouvier and his client, Russian oligarch Dmitry Rybolovlev, with freeports at the center of the controversy. Rybolovlev discovered that he had paid $118 million for a Modigliani masterpiece, while the true selling price was $93 million, resulting in Bouvier pocketing a $25 million commission. The scandal escalated when Rybolovlev accused Bouvier of cheating him out of over $1 billion, leading to Bouvier's indictment on charges of fraud and money laundering.

What makes art investible

It is important to delineate the types of art while making investments. When examining a universe of artists who produce art, there is a relatively small group of artists who are making “investible art”. 

Major modern and contemporary artists of the 20th century offer interesting investment opportunities, which can be likened to securities. The decision-making process involved in choosing an investment in art is similar to the process you would use when picking a stock. Investors look at factors like – how much volume is there with the artist? What are the market prospects? What is the relative value to other securities or other artists? 

With only a couple hundred investible artists out there, the first thing is to look at how their artwork is valued relative to their peer group. 

Collector Jim Hedges explains,

I’ve invested a lot over the years, and the work of an artist, a German artist called Sigmar Polke, who was a peer of a guy called Gerhard Richter – two of the greatest postwar artists from Germany. Well, the disparity in value between these two peers was five-to-one. It was an enormous, enormous disparity. So it was clear that there was a fundamental value play in the work of Sigmar Polke relative to Gerhard Richter. 

How to make money with art 

There are many different strategies in how art collectors can make money. 

Strategy 1: Equity Play

This is the obvious one. You buy the art you think is going to appreciate, and hold it. 

Strategy 2: Securitize Art

The traditional banking landscape does not lend money secured by art as collateral. 

There are various financial institutions that offer art collectors the opportunity to borrow money against their art collections for other investments. These include private banks, specialty art lending firms, and auction houses. Auction houses such as Christie's and Sotheby's also offer lending services to clients who consign artwork for sale. 

This strategy is for people with enormous wealth and great balance sheets / P&Ls who may be cashflow strapped. They have $10 million in paintings in their house and they want to put a $3 million deposit down on a real estate project for their next deal. They need short-term cash. They want to securitize their art, and borrow against it. They’re willing to pay high interest rates for a short period of time. 

They make money on the new investment and close out the loan. 

Strategy 3: Distressed People

They say there are three Ds that cause people to sell artwork – death, divorce, and debt. There’s an investment opportunity here from a distressed perspective. Jim Hedges, an art collector bought an art gallery that was distressed, turned it around, and liquidated the inventory. 

Strategy 4: Rent

Increasingly, there are companies out there that will create a corporate art collection. They will rent art from collectors. So, this asset class that has historically been viewed as illiquid, all of a sudden starts to have a rent. This is increasingly changing the way people think about art – if you can buy it and you don’t have terribly high management expenses (care/frame/store/ship/insured), you can generate some income while it is also creating ROI.

Blue-Chip Art: How normies (like me) can invest in art

People without enormous wealth, who want to invest in hard assets can do so via blue-chip art. 

Blue-chip art is artwork by recognized and established artists that are known for their long-term investment value, exceptional quality, and strong market demand. The term "blue-chip" originally came from the stock market, where it referred to the shares of companies with a history of stability and consistent growth, similar to how blue-chip art refers to artwork with a history of strong performance in the art market.

This art typically includes works by highly sought-after artists like Picasso, van Gogh, and Warhol, among others. These artists have a proven track record of strong auction results and their works are highly sought after by collectors, institutions, and museums. Blue-chip art is often viewed as a relatively safe long-term investment due to its high quality and demand, and it is considered a valuable asset in a diversified investment portfolio. 

Blue-chip artists have shown to perform far better than the S&P 500, than any fixed income instrument, and on par with private equity investments, which are historically considered the highest return strategy. The appreciation in the past 10-40 years has shown exponential growth with annual rates of return – from 15-20% annually. 

I’ve had conversations with people at MasterWorks – a company that allows people to invest in blue-chip art. 

Ultimately, art has not only demonstrated strong investment performance as an asset class, but it has also proven to be a valuable tool for families looking to align their philanthropic and tax strategies for effective tax mitigation. Plus, due to its limited liquidity and smaller market sizes, art is a useful asset for passing on wealth. Discounts on partnerships and family entities that hold artwork can be significant, making art an attractive option for wealth transfer.

Much of this piece has been lifted from Jim Hedges and his interview with Alan Olsen. Jim is one of the early leaders in the hedge fund and alternative investments industry + he is the author of Hedges on Hedge Funds.

References: 

Bloomberg
https://www.bloomberg.com/news/articles/2021-11-02/how-do-the-rich-avoid-taxes-billionaires-use-this-art-strategy#xj4y7vzkg?leadSource=uverify%20wall 

Groco 
https://groco.com/featured-guests/art-as-an-investment/ 

The New York Times
https://www.nytimes.com/2015/04/27/arts/design/tax-break-used-by-investors-in-flipping-art-faces-scrutiny.html 

Winston Art Group 
https://winstonartgroup.com/art-as-collateral/

Town & Country
https://www.townandcountrymag.com/leisure/arts-and-culture/a35032655/what-is-a-freeport-art-collections/

This piece is 26/50 from my 50 days of writing series. Subscribe to hear about new posts.