NEW YORK—As art values continue to sky-rocket, investors are slowly increasing their use of an Internal Revenue Service (IRS) code, called Section 1031, which makes it possible to defer paying capital-gains taxes by selling artwork and using the proceeds to buy more art.
With long-term capital-gains taxes on art and other collectibles at 28 percent—higher than the comparable rate for most other assets—this deferral can prove significant. During Section 1031 exchanges, most states, including New York and California, also allow the deferral of city and state taxes (but not sales taxes).
Section 1031, enacted in 1921, is used predominantly in real estate transactions—say, when one investment property is sold and the money is used to buy another investment property—and many businesses that facilitate these exchanges for artworks also are involved in real estate. Steven Waldman, who facilitates Section 1031 exchanges for art at the New York offices of LandAmerica, a provider of real estate transaction services based in Glenn Allen, Va., recalls a deal wherein a collector exchanged one painting by Pierre-Auguste Renoir for another. “I’m surprised people don’t take advantage of this more often, especially because of the hyper-appreciation of art,” Waldman told ARTnewsletter.
In Section 1031 exchanges, the asset being bought must be of equal or greater fair-market value than the asset sold; and only real or personal property qualifies (real property is land and anything attached to it; personal property is tangible property, except for real property and intangible property, such as copyrights and patents).
The assets also must be identified as investments or else earmarked for productive use in trade or business. (Before making a determination, the IRS examines individual patterns of behavior: If a collector appears to be trading in and out of artworks too actively, he, or she, may not be considered an “investor” for the requirements of this transaction.)
“Like kind” is another of the stipulations of the arrangement; in other words, the assets being bought and sold must be of the same type. When it comes to art, there are no clear guidelines on whether or not different media are considered “like kind” by the IRS, so most exchange coordinators recommend that paintings be exchanged for other paintings, sculptures for sculptures, and so on. (Exchange agents, or coordinators, transact the exchange.)
“The cleaner you have it, the better,” says Ralph Lerner, a partner at Sidley Austin,
New York, and coauthor of Art Law: The Guide for Collectors, Investors, Dealers, and Artists (Practicing Law Institute, 1998), who recommends this approach. In other words, Lerner notes, investors should follow the letter of the law.
A Section 1031 exchange requires that before the sale, the seller must notify an exchange agent of his or her intention to make the exchange. The agent then issues the documents required for the transaction. Importantly, the purchase agreement for the new piece must state that it is being bought as part of a Section 1031 exchange. The investor never takes custody of the proceeds from the sale; these funds are held by the exchange company in a segregated, bonded account until purchase of the new item(s) has been finalized.
Replacement property must be identified within 45 days of the sale of the relinquished property. Most exchange agents recommend identifying multiple potential replacement properties, or works of art, before the transaction begins. This helps to ensure that in case one deal falls through, the exchange still can be completed within the IRS-mandated time frame. Several pieces of art of an equal or greater total value may be used to replace the relinquished property. The quality of the art is not considered by the IRS.
Once a relinquished piece has been sold, the exchange company holds the proceeds and uses them to pay for the new item(s). The seller has 180 days from the time of the sale to complete the entire exchange. In order to report the Section 1031 exchange to the IRS, form No. 8824 must be completed and filed at tax time.
In a reverse Section 1031 exchange, the property to be purchased is first identified; then the buyer loans the money to the exchange agent to acquire the work on his behalf. Only then does the buyer decide which work of equal or greater value in his collection to sell.
The collector can buy and/or sell to anyone, whether another collector, a dealer or an auction house. Art dealers are not eligible to use Section 1031 exchanges for their businesses, but they can use them for their private collections.
Everything from Cattle to Sports Cars
The first Section 1031 exchange was made to sell and buy cattle, says Wendy L. Craft, an attorney with Hudson Land Company, New York, a firm that facilitates Section 1031 exchanges. Over the years the code also has been invoked for violins, sports cars and horses—only a male horse for a male and a female horse for a female. The first such exchange involving art, she notes, was conducted in the 1950s.
“Intention also plays a part in the exchange,” Craft explains. “If you intend to flip the replacement property, it’s not a good idea to do a 1031 exchange. What the IRS can prove, I don’t know. But if you line up a purchaser before you own the replacement property, I won’t do it.”
Lerner believes that owing to the complexity of Section 1031 exchanges, it’s not worth doing them unless the gain on the work to be sold is more than $500,000. “Otherwise, it’s a waste of time,” he says. “Legal fees and filing fees eat up the profit.” The art investor must comply strictly with the IRS requirements, he stresses. “There are no shortcuts.”