The following appeared in Apollo magazine online on December 4, 2017
What will Trump’s tax reforms mean for the art market?
The tax legislation proposals currently under consideration by the United States Congress contains a number of concepts that would affect the art market. One would eliminate the availability for art sales of so-called ‘1031’, or ‘like-kind’, exchanges, a provision that can defer payment of tax when property is sold and reinvested in similar property. While it is difficult to quantify the effect that passage would have, it would undoubtedly encourage more caution among investors and have a downward effect on the volume of art sale transactions.
A 1031 exchange offers the key benefit that the sale of the property involved will not incur capital gains tax if the requirements of the statute are met: the transaction must involve an exchange of ‘like kind’ property; and the property involved must be held or used in a trade or business, or for investment. So, for example, if an art dealer sells a work in her gallery’s inventory and delivers the proceeds to a nominated agent, known as a qualified intermediary, she can re-invest that money in another work and not pay a tax on any gain realised from the first work at the time of the sale. This tool is of no small consequence. The capital gains tax rate on the sale of art is 28 per cent, far higher than for many other kinds of assets like securities or real estate, which are taxed between 15 and 20 percent.
The mechanics of the exchange are precise and must be observed by the seller to qualify. First, the initial property is sold and the proceeds delivered to the intermediary. The seller then designates the replacement property or properties, which must be done within 45 days of the sale transaction. The acquisition must close within 180 days. If these deadlines are not met, the exchange is blown and the original sale transaction becomes fully taxable.
The value of this provision, as noted above, is the deferral of tax. If a property, such as a painting, is sold, capital gains tax must usually be paid on the increase in value over what was paid for it. If the seller can defer a payment of 28 per cent of that gain by exchanging it for like-kind property, there is a financial benefit (it being better to pay the same sum in the future rather than now and enjoy the time value of the 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, most of all the requirement that the art was being used in a trade or business.
Proposals to eliminate the 1031 exchange more broadly have surfaced before, but both the Tax Cuts and Jobs Act (which passed the House of Representatives) and the bill that just passed the Senate on 2 December would limit 1031 exchanges to real estate. These bills are not yet law; they differ in some respects and those differences have to be reconciled before a single bill can go to the President for signature (and passage into law). Making the case to the IRS that the art was held in for a trade or business is sometimes a challenge because it involves making the case that the art was not for personal enjoyment, but the availability of a 1031 exchange creates a driver in the frequency of transactions where the collector may perceive an opportunity to trade up on future value without taking a hit in the short term.
As far as international effects, the clearest one will be in the volume of objects brought to market. If sellers face a more certain short-term tax consequence, they may not consign the objects for sale. In a global market, that effect will be felt far beyond US shores.