There has been considerable coverage in the last week about so-called “like-kind” exchanges of art, and federal tax. This has been driven by two factors: President Obama’s 2016 proposed budget, which would eliminate the tax deferral on these “1031 exchanges” for art and collectibles, and a recent New York Times article entitled “Tax Break Used by Investors in Flipping Art Faces Scrutiny.” The prospect of actual change is dubious, but there is no question that the prospect of the elimination of this tax deferral means anyone who is considering such an exchange for their art and collectible collection should be paying attention.
The 1031 Basics
The basic rules for a 1031 exchange are well known, but it is always good to “remind ourselves” about what we “already know.”
An LKE must involve an exchange of “like kind” property. In addition, the property exchanged in both directions must be held for productive use in a trade or business or for investment. In the real estate industry, the “like kind” requirement is easy: all real estate is likekind with all other real estate. However, this “simple” rule is complicated by the fact that “real estate” has been interpreted in interesting and inventive ways. Real estate includes not only land and the improvements thereon, but also includes air rights, certain kinds of building rights and permits, riparian (water) rights, and even operating leases in oil and gas drilling ventures.
In a simple transaction (these are never really simple), the taxpayer sells the “relinquished” property, and the proceeds are delivered to the [qualified intermediary] to be held in a qualified escrow or trust account. The taxpayer then designates up to 3 replacement properties (or an unlimited number of properties representing up to 200% of the value of the relinquished property) within 45 days of the sale transaction. After that, the taxpayer has up to 180 days to close on the acquisition of one or more of the identified properties. If the taxpayer does not identify any properties within 45 days, or if the taxpayer identifies timely but does not close within 180 days, the exchange is “blown” and the original sale transaction becomes fully taxable.
The importance of this is the deferral of tax. If you sell a property, or a painting, you will pay capital gains tax on the increase in value over what you paid for it (the basis), for the most part. But capital gains tax on collectibles is 28 percent, so if you can defer that gain by exchanging it for like-kind property, you realize a financial benefit (it being better to pay the same sum in the future rather than now, since you will enjoy the time value of your money in the meantime). As always, the devil is in the details, and making a like-kind exchange of art requires careful respect for the requirements.
So what is the big deal? The Times characterizes this issue thusly:
The exchanges have become prevalent enough, and the cost to the government significant enough, that the Obama administration is seeking to eliminate them, a prospect causing no shortage of alarm in sectors of the art world.
There is much more to this story, however, than the critics in the article suggest. Tax deferral is not tax avoidance; they are simply different. If the reason for the statutory exchange provision is to stimulate the productive use of property, there is really no principled basis to target one kind of property (particularly the kind that is taxed at one of the highest rates already).
And while opponents characterize the exchanges in dire terms, the exchanges stimulate economic activity that would fall in their absence. An Ernst & Young study cited in the Times article suggests that “eliminating 1031 exchanges could, under some conditions, shrink gross domestic product by about $8 billion annually.”
Bottom line? Every year brings significant proposed changes to the tax code, most of which progress no further than that stage. But anyone hoping to defer that tax rate and make productive use of their assets in the meantime would do well not to take it for granted and to consider acting sooner rather than later.