UK: 2013 Tax Rate Changes Make 1031 Like-Kind Exchanges An Attractive Option For Art Investors

Two Congressional Acts, the 2010 Health Care Reconciliation Act and the American Taxpayer Relief Act of 2012, will affect tax rates in 2013. Art collectors will be subject to a 3.8% tax rate increase on the gain from the sale of art. Therefore, structuring a sale of art to qualify as an Internal Revenue Code Section 1031 Like-Kind Exchange may be an attractive option for art investors who wish to defer gain recognition.

Taxation of gain from the sale of art in 2013

Beginning in 2013, the 2010 Health Care Reconciliation Act imposes a 3.8% tax on certain investment income, as set forth in Internal Revenue Code Section 1411. This surtax for individuals is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over the threshold amount. The threshold amount is US$250,000 for a married couple filing jointly, US$125,000 for a married individual filing separately and US$200,000 for all other individuals. Among other things, the definition of 'net investment income' includes the net gain from disposition of property (other than property held in a trade or business). Therefore, this surtax will apply to gain from the sale of art.

The American Taxpayer Relief Act of 2012 does not change the tax rate of gain from art sales. The capital gains rate for collectibles, including art, as set forth in Internal Revenue Code Section 1(h), will remain at 28% for 2013. Therefore, in 2013, gain from the sale of art will be taxed at a combined federal rate of 31.8%.

1031 Like-Kind Exchange tax saving strategy

Internal Revenue Code Section 1031 provides for the non-recognition of gain or loss if certain qualifying property is exchanged solely for 'like-kind' property. Therefore, if an art collector is considering selling art and purchasing art, he or she may consider structuring the sale and purchase as one exchange transaction to avoid gain recognition on the sale that would otherwise occur if the sale and purchase are treated as two separate transactions.

However, the Internal Revenue Service has strict requirements that must be met in order for a transaction to qualify as a non-recognition, like-kind exchange. If an art collector decides to engage in a 1031 Like-Kind Exchange transaction, it is worth noting the following requirements.

  • The collector must hold art for investment purposes. Neither the Internal Revenue Code nor the Treasury Regulations define 'held for investment' for purposes of Section 1031.
  • There must be a written exchange agreement signed and dated by the collector and the agent.
  • The agent must be a 'qualified intermediary' as defined by the Treasury Regulations. Specifically, a gallery to which you have consigned art within the last two years will not qualify as a qualified intermediary.
  • The property exchanged (commonly referred to as the 'Relinquished Works') must be exchanged solely for property of like kind (commonly referred to as the 'Replacement Works').
  • The collector has 45 days to identify the Replacement Works. The collector can identify up to three Replacement Works regardless of value. If more than three Replacement Works are identified, the total value of the Replacement Works cannot exceed two-hundred percent of the total value of the Relinquished Works.
  • If the collector wishes to conduct this exchange in reverse, the collector cannot take possession of the Replacement Works until the exchange is completed.
  • The exchange must be completed, with all Relinquished Works, Replacement Works and funds transferred, within 180 days of the date that the exchange begins.
  • The collector must file IRS Form 8824, Like-Kind Exchanges, with his or her tax return for the year during which the exchange began.

Please note that this is not a complete list of the Internal Revenue Service's requirements for 1031 Like-Kind Exchanges. Therefore, while utilising a 1031 Like-Kind Exchange can be an attractive tax saving strategy, given the 31.8% federal tax rate on gain from art sales, an art collector should consult with an attorney before the sale and purchase of art to ensure that the Internal Revenue Service's requirements for the exchange are satisfied.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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