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					PLANNING WITH UNUSUAL ASSETS—TANGIBLE PERSONAL PROPERTY, VACATION HOMES AND MORE OPPORTUNITIES AND PITFALLS

Tama Brooks Klosek Vinson & Elkins L.L.P. September 6, 2007

PART I GIFTS TO INDIVIDUALS
1. Lifetime Gifts. a. Use of Annual Exclusion. Tangible personal property or undivided interests in vacation property may be transferred in satisfaction of the annual exclusion amount (currently $12,000 per individual). I.R.C. § 2503(b). i. Determining the value of the property may present practical problems and increase the costs of transferring the property if an appraisal is required. ii. Transfers of tangible personal property or vacation property may not be the most efficient use of the donor's annual exclusion. iii. Fractionalized ownership of property presents various problems discussed below. b. Taxable Gifts. All gifts of in excess of the annual exclusion amount must be reported on a gift tax return (Form 709). Adequate disclosure on Form 709 is required in order to begin the running of the statute of limitations regarding the gift. (Treas. Reg. §301.6501(c)-1(f)(3)). Transfers will be adequately disclosed if detailed information set forth in the regulations is provided or if, in lieu of such information, a qualified appraisal is submitted (discussed below). The value of the property should be determined by reference to the retail marketplace in which the item is most commonly sold in any given situation. (Treas. Reg. §25.2512-1). i. IRS Art Advisory Panel. In general, any taxpayer's appraisal of a single work of art with a claimed value of $20,000 or more will be referred for review by the Art Advisory Panel which is comprised of 22 experts in all areas of art. 1. Photos and other essential information and materials necessary for a fair market value determination will be requested. 2. If the Panel questions the taxpayer's value they will recommend a specific valuation which usually becomes the position of the Service. c. Effectuating the Transfer. All transfers of real property must be made by a properly executed and filed Deed. All transfers of tangible personal property should be made by Deed of Gift. The donor should change any insurance on the property to the new owner and should not retain any interest in the property which may cause estate tax inclusion under §2036.

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d. Discounts. i. Fractional Interests Gifts. Consider making fractional interest gifts of vacation property or tangible personal property to noncharitable beneficiaries. 1. Vacation Property. Co-ownership of vacation property presents a variety of issues including but not limited to management of the property, decorating, maintenance, equipment, scheduling, sales and rentals. The donor should carefully consider each donee's desire to use the property and ability to pay for the expenses associated with the property. a. Undivided Interest Discounts. Undivided interests in real property are typically discounted below the value of the real estate as a whole due to factors including the lack of marketability, lack of control, and possibility of complications caused by partition. (Knapp v. C.I.R., T.C. Memo 1977-389; Propstra v. U.S., 680 F.2d 1248 (9th Cir. 1982); Baird v. C.I.R., T.C. Memo. 2001-258). 2. Tangible Personal Property. Although uncertain under current law, it may be possible to obtain fractional interest discounts on both a fractional interest gift of tangible personal property and the retained interest. a. The IRS takes the position that no discount should be allowed for a gift of a fractional interest in tangible personal property (Rev. Rul. 57-293; PLR 9303007; PLR 200223013). b. The Tax Court in Estate of Scull v. C.I.R., 67 T.C.M. (CCH) 2953 (1994), allowed a 5% discount on the decedent's 65% undivided interest in an art collection to reflect the uncertainties involved in the acquisition of the interest which was the result of a divorce proceeding being appealed. c. The District Court in Stone v. U.S., 2007 WL 231897 (N.D. Cal. 2007) found that a fractional interest discount is appropriate to account for (i) legal fees required to enforce a co-owner's right to partition; (ii) the actual costs of selling the property and (iii) the uncertainties involved in waiting to sell the art until after the partition action is resolved and left it up to the parties to confer and determine the appropriate discount.

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d. The ability to partition under §23.001 of the Texas Property Code, or similar statutes of other states, may support any claimed valuation discounts based on the costs of partition. 3. Co-ownership Agreements. To establish the relationship between co-owners and to support any claimed undivided interest discount, the co-owners should execute an agreement setting forth their relationship. The agreement should give each owner the right to exclusive possession commensurate with his ownership interest, state that each owner will pay his share of the costs associated with ownership of the property (insurance, maintenance), and that all proceeds from the sale of the property will be divided among the co-owners in accordance with their respective percentage ownership interests. Rights of first refusal and other transfer restrictions may also be included. ii. Partnership Property. In general, personal use property should not be contributed to a limited partnership in order to support the business purpose of the partnership. However, vacation property which is income producing property (such as a farm or ranch) and tangible personal property which is also investment property (such as art, coin or stamp collections) may be contributed to a partnership. Minority interest and lack of marketability discounts may be applied to determine the value of partnership interests. iii. Qualified Personal Residence Trusts. If vacation property is likely to appreciate substantially, a QPRT may be considered. (Treas. Reg. § 27025). In order to reduce the value of the remainder interest in the property passing to family members, consider transferring undivided interests in the property to the QPRT. iv. Joint Life Estate/Remainder Purchases with Non-Family Members. To reduce the value of vacation property and tangible personal property, consider joint purchases of life estate and remainder interests with individuals who are not family members (such as aunts and uncles) to avoid the application of § 2702(c). v. GRITs for Non-Family Members. Consider establishing GRITs with nonfamily members to avoid the "zero value rule" under § 2702. e. Penalties for Substantial and Gross Valuation Misstatements. If the value claimed for gift tax purposes is 65% or more of the amount determined to be the correct valuation, the donor will be required to pay a penalty equal to 20% of the underpayment of tax. If the value claimed is 40% or more, the penalty will equal 40% of the underpayment of tax. (I.R.C. § 6662).

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Testamentary Gifts. a. Appraisal. An appraisal of tangible personal property must be obtained in order to establish fair market value for estate tax purposes if the total assets having artistic or intrinsic value exceed $3,000. (Treas. Reg. §20.2031-6(b)). The appraisal should set forth the fair market value of the property as determined in the retail marketplace in which the item is most commonly sold in any given situation. (Treas. Reg. § 20.2031-1(b)). b. Penalties for Substantial and Gross Valuation Misstatements. If the value claimed for estate tax purposes is 65% or more of the amount determined to be the correct valuation, the donor will be required to pay a penalty equal to 20% of the underpayment of tax. If the value claimed is 40% or more, the penalty will equal 40% of the underpayment of tax. c. Avoiding Probate. Consider contributing vacation property and tangible personal property to partnerships or revocable trusts to avoid probate. i. In State. Many individuals do not want valuable property listed on a probate inventory. ii. Out of State. Individuals may wish to avoid the expense of an out of state probate or evidence of domicile in a state where they keep tangible personal property (for state income and estate tax purposes). d. Securing the Property. Where there is valuable personal property in an estate, the executor needs to take immediate steps to secure the premises and to obtain adequate insurance. Some auction houses will cover the property under their umbrella policies immediately upon taking possession (even if only for purposes of appraisal). e. Disposition. There are a number of issues which arise when making a testamentary disposition of tangible personal property. i. Specific Bequests vs. Precatory Nontestamentary "Lists". Clients often wish to dispose of tangible personal property by specific bequest but do not want to revise their wills whenever they decide to make an alternate disposition or to reflect the sale of the property. However, if an individual opts to write a letter to his executor specifying his preferences for dispositions of tangible personal property, the executor will not be bound by the testator's wishes. Clients should be informed that certainty regarding the disposition is only achieved by making a specific bequest of the property. ii. Formal Selection Alternatives. 1. Executor's Decision. Allow the executor to make the decision in the executor's sole discretion. 4

2. Auctions–Monopoly Money. The executor holds an auction where each beneficiary will use "monopoly money" to bid on the items that the beneficiary desires. Each beneficiary will be given "monopoly money" equal to the beneficiary's fractional share of the tangible personal property multiplied by the value of the property for estate tax purposes. 3. Partial Lottery–Choice By Lots. Each beneficiary will be entitled to a specified number of turns which corresponds to the beneficiary's fractional share of the tangible personal property. Each beneficiary will select an item to satisfy his share of the gift in the order specified by a number drawn by the beneficiary at the beginning of the round. Rounds will continue until all of the property has been selected or the beneficiaries decline to make any more selections. 4. Full Lottery–Random Choice By Lots. Similar to the partial lottery, the beneficiaries select random numbers (instead of items) which will correspond to an unknown item of tangible personal property. The rounds continue until all of the numbers have been drawn. iii. Equalization Clauses. Clients often wish to equalize gifts of tangible personal property among beneficiaries by providing for cash gifts to equalize the value of the property received by the beneficiaries. Result: A tension between beneficiaries desiring high values to increase the value of their equalization gifts and low values for estate tax valuation purposes. This problem should be addressed early on in an estate's administration so that all of the beneficiaries are aware of the issues and are not later shocked or disappointed at the value of the equalization gift. If equalization clauses are not used, consideration should be given to the allocation of the taxes associated with the tangible personal property. f. Sale of Property By the Estate. If the executor sells vacation property or tangible personal property, the following problems may arise: i. Buyer's Premium. When collectibles are purchased at auction houses, a buyer's premium is added to the final auction bid price and is paid by the buyer. The IRS has stated that when an estate sells collectibles at auction, it must use the hammer price plus the buyer's premium as the estate tax value. (PLR 9235005). ii. Deductibility of Sale Expenses. The expenses of the sale (commissions, buyer's premium) may be included as part of the value of the property for estate tax purposes but may not be deductible if not "necessary" expenses or if the property is not required to be sold by the will. (Treas. Reg. §20.2053-3(d)(2)).

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g. Long Term Protection of Valuable Property ("Keeping it in the Family"). i. Trusts. Although tangible personal property is usually distributed outright, consider using trusts for dispositions of valuable tangible personal property. Trusts may also be used for dispositions of vacation property. The terms of the trust should allow for each beneficiary's use of the property. The trustee of the trust should be carefully selected. 1. QTIP Trusts. If the property will be distributed to a QTIP trust, the will must provide for use by the surviving spouse and permit the surviving spouse to require the trustee to convert the property to income producing property. ii. Life Estate/Remainder Arrangements. Consider transferring life estates and remainder interests to keep valuable property "in the family." iii. Rights of First Refusal/Transfer Restrictions. Consider imposing transfer restrictions on the property or giving other family members rights of first refusal. h. Discounts. i. Fractional Interests. 1. Transfers of Fractional Interests. If the decedent owns a fractional interest in vacation property or tangible personal property (such as a one-half community property interest) it may be possible to obtain discounts for estate tax valuation purposes. 2. Disclaimers of Fractional Interests. If the surviving spouse disclaims a fractional interest in vacation property or tangible personal property transferred outright to the surviving spouse at the death of the first spouse, it may be possible to preserve fractional interest discounts at the surviving spouse's death. 3. Opportunity for Valuation Diversity at Second Death. It is clear that as long as the surviving spouse is not given a general power of appointment, the assets of a QTIP should not be aggregated with the surviving spouse's other property for estate tax valuation purposes. (Estate of Bonner v. U.S., 84 F.3d 196 (5th Cir. 1996); Estate of Mellinger v. Comm'r, 112 T.C. 26 (1999); Estate of Nowell v. Comm'r, T.C. Memo 1999-15; Estate of Lopes v. Comm'r, T.C. Memo. 1999-225; Field Service Advisory 200119013). Result: Fractional interest discounts (if allowed) should be preserved at the death of the surviving spouse if a fractional interest is owned by the QTIP and the surviving spouse.

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ii. Blockage Discounts. Blockage discounts may be available depending on the type of property. 1. Artist Example. If a large number of works of a single artist are transferred at death (or during life), the transferor may be able to claim a blockage discount which would result if all of the works "flooded" the market. 3. Pitfalls. a. Remainder Beneficiaries. If the remainder beneficiary of multiple trusts owning fractional interests in tangible personal property is not the same, individual items will be owned by various beneficiaries at the end of the trusts' terms which can cause problems unique to shared ownership of vacation property and tangible personal property. This issue will also arise if there are multiple remainder beneficiaries at the end of a trust's term and the trust owns the entire interest in the property or when fractional interest gifts of such property are made outright to multiple beneficiaries. b. Benefits vs. Burdens. Co-ownership and partnerships often work well during the donor's lifetime and may have tax benefits, however, these arrangements often unravel after the donor has passed and can create family discord. c. Definition of Personal and Household Effects. Definitions of personal and household effects should be reviewed by the attorney and the client to ensure that items passing pursuant to this gift are passing in the desired manner and to the desired beneficiaries.

PART II: CHARITABLE TRANSFERS
1. Lifetime Gifts to Charity. a. Requirements for Claiming a Charitable Deduction. i. Status of the Organization. Donors should confirm the charitable status of any potential donee. The maximum allowable deduction for gifts of tangible personal property will be obtained by making gifts to public charities because deductions for contributions of capital gain property to a private foundation are limited to the donor's cost basis. (Unless otherwise provided, all charitable giving techniques discussed below refer to contributions to public charities).

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b. Type of Property. i. Capital Gain Property. Donors may receive favorable tax treatment for donations of tangible personal property to a public charity because they may claim a full fair market value charitable deduction without recognizing gain at the long-term capital gains rate of 28% for collectibles or 15% for non-collectibles. 1. Related Use Rule. If a donor contributes tangible personal property, such as a work of art or a collection, the donor will only be able to take a charitable deduction equal to the fair market value of the donated property if the property will be used by the public charity for a use consistent with its charitable purpose. If the property contributed will not be used for purposes related to the public charity's tax exempt status, the charitable deduction will be limited to the donor's cost basis in the property. (I.R.C. § 170(e)(1)(B)). 2. Dispositions of Donated Tangible Personal Property. a. Within 1 Year. The donor's charitable deduction will be limited to the lesser of the property's fair market value or basis if the donated property is disposed of by the charity before the end of the taxable year of the donation unless the donor certifies under penalty of perjury that (a) the property was related to the charity's exempt purpose and describes how the property was used and how it furthered the charity's exempt purposes or (b) the intended use of the property by the charity at the time of the contribution has become impossible or infeasible to implement. (I.R.C. § 170(e)(1)(B)). b. Within 3 Years. If the property is disposed of before the last day of the 3 year period beginning on the date of the contribution, the donor is required to include in income the excess of the value of the deduction with respect to the property over the donor's basis unless the same type of certification described in 2(a) is made. (I.R.C. § 170(e)(7)). ii. Ordinary Income Property. Tangible personal property may be ordinary income property if it was created by the donor (such as the artist), was received by the donor as a gift from the creator, held for less than one year or would produce a capital loss if sold. The charitable deduction for donations of ordinary income property is limited to the donor's cost basis. (I.R.C. § 170(e)(1)(A)).

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iii. Taxidermy Property. The charitable deduction for contributions of taxidermy property is limited to the lesser of the donor's basis in the property (defined as the cost of preparing, stuffing and mounting) or the fair market value. (I.R.C. § 170(e)(1)(B)(iv)). c. Charitable Income Tax Deduction Limitations. i. Ordinary Income Property Percentage Limitation. A contribution of ordinary income property to a charity is limited to the donor's cost basis in the property and may only be deducted to the extent that the donor's aggregate contributions for the year do not exceed 50% of the donor's contribution base for contributions to a public charity and 30% of the donor's contribution base for contributions to a private foundation. (I.R.C. § 170(b)(1)(A) and (C)). ii. Capital Gain Property Percentage Limitation. A contribution to a public charity of capital gain property that meets the related use rule (described above) is allowable as a charitable deduction to the extent of the full fair market value of the property on the date of contribution if the donor's aggregate contributions for the year do not exceed 30% of the donor’s contribution base. Deductions for contributions of capital gain property to private charities are limited to the donor's cost basis in the property and will be allowed to the extent the donor's aggregate contributions do not exceed 20% of the donor's contribution base. (I.R.C. §§ 170(b)(1)(B) and (C)). iii. Carry Forward for Excess. If annual contributions exceed these percentage limitations, the excess may be carried forward and deducted for 5 years. (I.R.C. § 170(d)(1)). iv. Phase Out of Tax Benefits. These general rules are subject to certain reductions or "phase outs" depending on factors such as the donor's total income. (§68 limitation on itemized deductions; AMT). Accountants may assist prospective donors by projecting the potential tax savings of a charitable contribution, including the application of any applicable phase out of tax benefits to the donor. d. Partial Interest Gifts. Many donors want to transfer property to a charity and obtain the immediate income tax and estate-planning advantages without giving up possession of the property. i. Remainder Interests. 1. Tangible Personal Property. A donation of a remainder interest in tangible personal property is not a deductible interest for income tax or gift tax purposes. (I.R.C. § 170(f)(3)(A)).

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2. Personal Residence or Farm. Although in general a transfer of a remainder interest not in trust is not a deductible interest, there is a special provision providing that an individual is entitled to an income tax and gift tax charitable deduction for the transfer of a remainder interest in a personal residence or farm to a charity. (I.R.C. § 170(f)(3)(B)(i)). ii. Fractional Interest Gifts of Tangible Personal Property. The Pension Protection Act of 2006 put an end to the commonly used technique of donating fractional interests in tangible personal property to a charity by limiting the income, estate and gift tax charitable deduction to the lesser of the fair market value of the property at the time of the initial fractional contribution or the fair market value at the time of the additional contribution. (I.R.C. § 170(o); 2055(g); and 2522(e)). e. Bargain Sale. Donors may consider a bargain sale to charity of vacation property or tangible personal property. The donor/seller will be required to recognize gain on the sale portion and the gift portion will be allowed as an income tax and gift tax charitable deduction. The donor/seller should be careful to disclose his donative intent in the sale documentation. f. Loans to Charities. No income tax deduction is allowed for a loan of property to a charity because this is not a transfer of an undivided fraction of the owner's entire interest in the property. The loan will not be subject to gift tax, and the value of the transferred property will be included in the donor's estate if he dies during the "term" of loan. g. Charitable Remainder Trusts. A charitable remainder trust is generally not a suitable vehicle to transfer ownership of vacation property or tangible personal property unless a sale is desired. (Rev. Rul. 73-610). However, if the donor wishes to sell low basis vacation property or tangible personal property, the capital gains tax on the sale of the property may be deferred through the use of a lifetime charitable remainder trust. (PLR 9452026). Because of the related use rule, the charitable deduction available for a transfer to a charitable remainder trust of tangible personal property would be limited to the basis allocable to the remainder interest in the property passing to the charitable beneficiary. h. Creation of Private Operating Foundation or a Supporting Organization. Donors with large collections should consider creating a private operating foundation or a supporting organization to keep large collections together for public enjoyment. Since both private operating foundations and supporting organizations are treated as public charities for income tax purposes, contributions may be deductible to the extent of full fair market value (subject to limitations discussed above). In addition, for private operating foundations, the donor and the family may retain control over the collection.

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Conservation Easements. If a vacation property has conservation value, a donation of a conservation easement entitles the donor to an income and gift tax charitable deduction. (I.R.C. §§ 170(h) and 2522(d)). Completion of a Gift of Tangible Personal Property. A gift of tangible personal property will not be deductible as a charitable contribution until the property is delivered to the charity or the donor executes a Deed of Gift.

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k. Appraisals. i. Property in Excess of $5,000. If the value of the property which is donated (or the aggregate of similar items of property donated during one year) exceeds $5,000, the donor must obtain a qualified appraisal for the contributed property, attach an appraisal summary to the donor's tax return and maintain records regarding the contribution. ii. Qualified Appraisal. The information which must be provided in a qualified appraisal includes a description of the property; the physical condition of the property; the date of the contribution; the terms of any agreement entered into between the donor and the donee; the name, address and identification number of the qualified appraiser; the qualifications of the appraiser; a statement that the appraisal was prepared for income tax purposes; the date the property was appraised, the appraised fair market value of the property on the date of contribution; the method of valuation used; and the specific basis for the valuation. A qualified appraisal must be prepared within 60 days of the contribution by a qualified appraiser. A qualified appraiser is an individual who performs appraisals on a regular basis; is qualified to make appraisals of the type of property being valued; and is not a person who is the donor, the donee, or any person employed by or related to the donor or the donee. iii. Advance Rulings. Taxpayers may obtain an advance ruling determination of the value of tangible personal property transferred by gift or bequest to a noncharitable beneficiary or a charity. The ruling will be issued if at least one item of property transferred has a value of $50,000 or more. (Rev. Proc. 96-15). 1. The request must be made prior to filing the income, estate or gift tax return and must include a qualified appraisal. 2. The taxpayer may rely on the Statement of Value received from the IRS. 3. If the taxpayer disagrees with the IRS determination of value, the taxpayer must attach the Statement of Value to the return but may provide additional information in support of a different valuation.

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Donee Organization. If a charity receives property for which an income tax charitable deduction of more than $5,000 was claimed and the property is sold within 3 years, the charity must file an information report with the IRS.

m. Penalties for Substantial and Gross Valuation Misstatements. If the value claimed for income tax charitable deduction purposes for any property donated is 150% or more of the amount determined to be the correct valuation, the donor will be required to pay a penalty equal to 20% of the underpayment of tax. If the value claimed is 200% or more, the penalty will equal 40% of the underpayment of tax. n. Substantiation Rules. i. Contributions in Excess of $250. No charitable deduction is allowed for a gift of $250 or more unless the donor obtains a written acknowledgement from the charity (before the taxpayer files his return) with sufficient information to evidence the amount of the deductible contribution. The written acknowledgement must contain (i) the amount of cash and a description of any property (but not necessarily a value) contributed and (ii) a statement whether the charity provided any goods or services in exchange for the contribution. 2. Testamentary Gifts to Charity. a. Complete Testamentary Gift. If an individual transfers property to a charity, the deceased individual's estate will receive an estate tax charitable deduction to the extent of the fair market value at the date of death. (I.R.C. § 2055). i. Sale by the Executor. If the executor sells the property, unless the will requires such a sale, the expenses of the sale may not be deductible and may result in disparity between the estate tax value of the property and the value of the charitable deduction. ii. Sale by the Charitable Beneficiary. If the property is sold by the charitable beneficiary, rather than the estate, the problem of nondeductible expenses will be resolved and state sales taxes may be avoided. b. Partial Testamentary Charitable Transfers. i. Conservation Easements. If a vacation property has conservation values, a deduction for the value of a conservation easement is also available for estate tax purposes. (I.R.C. § 2055(f)). ii. Testamentary Charitable Remainder Trusts. Similar to the lifetime charitable remainder trust, a testamentary charitable remainder trust should generally not be used to transfer ownership of vacation property or tangible personal property unless a sale is desired. The estate will obtain an estate tax charitable deduction for the value of the remainder interest. The trust will be exempt from income taxes; however, because of the step12

up in basis at death, a lifetime charitable remainder trust is usually preferred to take advantage of the deferral of the capital gains tax.

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