Artfully Deferring Taxes

Volume 26 No. 4

by

K. Eli Akhavan is an attorney with the Mineola, New York, firm of Meltzer, Lippe, Goldstein & Breitstone, LLP.

Appreciating Art

Although the Great Recession has left many with depreciated assets, many investors in the art market have seen their artworks increase in value. In fact, for 2011, the Mei Moses World All Art Index (which tracks art sales across several categories) returned 10.2% while the S&P 500 Index returned 0%.

Art investors, including individuals, corporate collectors, and art funds, that own appreciated works may desire either to cash out of their investment or to replace their artworks with new ones. Applying a technique that is generally used by real estate investors, an art investor may be able to sell an artwork the investor owns, purchase another artwork, and defer the tax liability on the gain.

Tax-Deferred Exchanges

Generally, when a taxpayer sells or exchanges his property, he must report and pay tax on the recognized gain. For example, if a taxpayer has property with a tax basis of $90 and exchanges it for property with a fair market value of $100, he recognizes a gain of $10. IRC § 1031 provides a well-known exception, the “1031 Exchange,” to this general rule. Under a 1031 Exchange, a seller can exchange his property for another property of “like-kind” and defer tax on any gain that ordinarily would be recognized. Ultimately, the seller will have to pay the deferred tax on the taxable disposition of the “replacement” property acquired in the exchange.

There are four requirements to qualify for a 1031 Exchange:

  1. there must be an exchange;
  2. the exchange must be of property that qualifies under IRC § 1031(a);
  3. the replacement property must be of like-kind to the property relinquished; and
  4. both the relinquished property and the replacement property must be held for productive use in a trade or business or for investment.

Brushstrokes of the Deferral

Although 1031 Exchanges are commonly used in the real estate industry, they can be used in the art world as well. If an art investor wishes to exchange one artwork (categorized as “collectibles” under the Code) for another, he can receive significant tax deferral in a 1031 Exchange. The gain from the disposition of a collectible is currently taxed at a maximum capital gains rate of 28%, but a 1031 Exchange will allow the taxpayer to defer the gain. A 1031 Exchange also can allow art funds and corporate collectors, which often own highly appreciated artworks, to defer capital gains tax while disposing of art assets with a low tax basis.

For example, an art investor purchases a rare Old Master painting for $1 million. After 10 years, the value of the piece has increased to $2 million, and the investor wants to sell it. In addition, the investor’s wife has been insisting that they purchase another painting she saw at a local art gallery for $2 million. Without a 1031 Exchange, the investor would sell the painting for $2 million and pay federal income tax at the rate of 28% (almost twice as much as the 15% rate for most other capital assets) on the $1 million gain. The result is a $280,000 tax liability, leaving the investor with only $1.72 million to purchase the new painting to make his wife happy.

Assuming that the investor complies with the requirements and mechanics of a 1031 Exchange, however, he can “exchange” the Old Master painting for a $2 million replacement Old Master painting from the gallery without having to pay the $280,000 capital gains tax at the time of the sale. The investor will have to pay the capital gains tax only when he ultimately sells the replacement Old Master painting. Any equity not reinvested from the exchange will be taxed at normal applicable capital gain tax rates.

Suppose that the dealer in the scenario wishes to sell the investor the painting but does not want to receive the investor’s painting in exchange—the dealer just wants the cash. The investor can still “exchange” his painting for the replacement painting through the use of an “exchange agent.”

Eligibility for a 1031 Exchange

Classification of Seller

Investors face many complexities when completing a 1031 Exchange. They must prove that the property they are exchanging is being held for productive use in a trade or business or for investment. They cannot collect the art solely for their personal aesthetic pleasure. Furthermore, the taxpayer cannot hold the artwork as a “dealer” or be someone that is engaged in the trade or business of selling artworks primarily to customers (that is, holding art as inventory). As a result, many art galleries may not be able to take advantage of the 1031 Exchange.

But, if an art dealer has a designated collection of artwork held for investment that he desires to trade, he may qualify for a 1031 Exchange. A dealer must keep careful records documenting that the artwork in question was held primarily for investment rather than for resale purposes. Many dealers maintain their own private collections, so they may be able to demonstrate that they have a history of not offering certain pieces for resale, which could make the investment artwork eligible for a 1031 Exchange.

Like-Kind

Another issue is that the exchanged artworks must be of “like-kind” with each other, but the IRS does not provide much guidance on what this means for artworks. For example, can a Rodin sculpture be exchanged for a Roy Lichtenstein painting? In giving advice to taxpayers, practitioners generally use an IRS ruling relating to involuntary conversions under IRC § 1033. The ruling provides that lithographs, oil paintings, and watercolors are not of “similar” or “related in use” (a somewhat narrower standard than “like-kind” under IRC § 1031). Accordingly, art investors are well advised that paintings can be exchanged only for other paintings, and sculptures can be exchanged only for other sculptures. But even within the various genres, it is not clear what constitutes a like-kind exchange. For example, is a Rembrandt of like-kind to a Jackson Pollock?

Other Matters on the Palette

The same stringent timing requirements that govern any 1031 Exchange also apply in an artwork 1031 Exchange. For example, the artwork replacing the sold work must be unambiguously designated in writing no later than 45 days after the sale of the relinquished artwork. In addition, the investor must take possession and ownership of the replacement artwork no later than 180 days after the date of the transfer of the relinquished artwork. Accordingly, those who wish to purchase art at a Sotheby’s or Christie’s auction must ensure that the auction houses respect these time frames.

Finally, the replacement piece of artwork needs to be of a value equal to or greater than the relinquished artwork. In making this computation, the assumption of debt to finance the transaction counts toward the value of the replacement piece.

I Must Have That Picasso—Going in Reverse

Often an art investor is at an art auction and would like to buy a work on the spot even though he does not want to sell any pieces from his collection before the purchase. By using the “reverse exchange,” the investor can purchase the replacement artwork first and sell the artwork that will be sold in the exchange up to 180 days later. In this exchange format, either the relinquished artwork or the replacement artwork must be parked with a “qualified intermediary” during the exchange period, with proper documentation for the exchange transactions.

I Must Have All the Picassos—Exchanging for Multiple Works

Assume that an art investor wants to sell one work, but wants to diversify and purchase many works with the proceeds. The 1031 Exchange rules allow such a transaction. For example, if 15 years ago an art investor bought a sculpture for $1 million, he can now sell the sculpture for its current price of $10 million and buy 10 new sculptures for $1 million each and pay no capital gain tax at the time of the sale. The investor just has to ensure that the 10 new pieces are of like-kind to the sculpture he sells.

Although specific rules apply for identifying potential replacement works of art, the number of works exchanged is not a factor in achieving a successful tax deferral. The determining factor is whether the investor has reinvested the entire net proceeds from the sale (sale price less expenses) in one or more replacement “like-kind” properties.

Sold to the Gentleman in the Back—Art Auctions

A 1031 Exchange can be used when selling or purchasing artwork at an auction. The investor should notify the auction house and contact the qualified intermediary before closing on the sale or purchase of artwork at an auction. Accordingly, investors contemplating purchases at an art auction should plan well in advance of the auction date with the auction house representatives.

Conclusion

Art investors with appreciated artworks can obtain beneficial tax results through a 1031 Exchange. As the rules and regulations allowing such a transaction are complex and strict, art investors should ensure that they comply with the necessary Code provisions to ensure they qualify for tax deferral. The 1031 Exchange is becoming more popular in the rarefied world of art investors. Proper planning and advice, however, must be sought before implementing this tax deferral strategy.

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