As art prices reach dizzying heights, especially in the contemporary art space, California collectors who wish to sell are faced with a capital gains tax approaching 45%. Many sophisticated collectors are familiar with IRC Section 1031 which permits tax-free exchanges of real estate, and are surprised to discover that it is possible to accomplish a tax-free exchange of art under the same section.
Although the availability of IRC Section 1031 for art exchanges is clear, there are some unique issues facing the collector who wishes to take advantage of the section:
- The threshold criterion for effecting a Section 1031 exchange is that the owner must be an investor. An investor is someone who purchases property primarily to make a profit. While virtually every art collector will say that he or she wants to make a profit on the art that he or she purchases, for most collectors, the profit motive is secondary to the intangible benefits of collecting art. It may be possible for the collector to segregate a group of works of art and have those works be treated as investment assets for purposes of IRS Section 1031 exchanges, while maintaining a portion of an art collection as a “collection” that is not eligible for Section 1031 treatment.
- Another element of a Section 1031 exchange is that the property exchanged must be “like kind.” In the real estate context, virtually any type of real property asset is deemed to be like kind to any other real property asset. For example, raw land can be exchanged for an apartment building or an apartment building can be exchanged for a commercial building. There is very little authority as to what constitutes like kind for works of art. What authority there is suggests that the IRS is not prepared to treat all works of art as like kind. For example, a painting is not like kind to a sculpture. It is not clear whether a watercolor is like kind to an acrylic, or whether a collage in a frame is like kind to a painting in a frame. In a somewhat related area dealing with involuntary conversions under IRC Section 1033, the IRS has taken a fairly narrow view. The standard under IRC Section 1033 is somewhat different than the like kind standard of IRC Section 1031. Under Section 1033, the replacement property must be “similar or related in service or use to the property converted.” Under this standard, the IRS determined in a private letter ruling (PLR 8127089) that works of art in a particular medium cannot be replaced with works of art in any different medium. It is not certain that the IRS will be so restrictive in interpreting IRC Section 1031, but there is a risk that it will be.
- A third element of a like kind exchange is that the property that is acquired must be held for investment. If the collector is an investor with respect to the work of art that is given up, it is likely, although by no means certain, that the property that is acquired will be held for investment.
- The last element of a successful 1031 exchange involves the mechanical requirements for the exchange. Generally, the exchange requires a qualified intermediary to hold the proceeds of the sale of the work that is being given up, and to purchase the work that is being acquired. A qualified intermediary is more like an escrow company that is in the business of facilitating tax-free exchanges, but which does not act as a dealer. If the collector receives the proceeds from the sale, the fact that the collector uses the proceeds to purchase art will not satisfy the technical requirements of a Section 1031 exchange. Likewise, an investor who gives a work to a dealer for sale, and then gets a “credit” with the dealer against a subsequent purchase of art, does not qualify for Section 1031 exchange treatment unless the dealer is a qualified intermediary, which is not very common. Depending on the complexity of the transaction, the fees for a qualified intermediary usually are between $750 and $1,500, which is well worth the service that a qualified intermediary provides to make certain that the exchange complies with the various technical requirements.
If there is a successful Section 1031 exchange, the basis of the exchanged work carries over to the acquired work. The imposition of income tax is delayed until the acquired work is sold or avoided if the owner dies owning the work, and the estate receives a new income tax basis equal to the work’s fair market value.
While the ability to accomplish a Section 1031 exchange for works of art is usually more challenging than accomplishing an exchange of real estate, the possibility of a successful exchange should not be overlooked if the heavy income tax burden on sales of art is to be postponed or avoided.