The International New York Times recently reported on a "little-known" provision in the federal tax code, referred to as a "like-kind" or 1031 exchange (named after the section of the tax code that allows it), which has become an increasingly used tactic among high-end art buyers who are seeking to defer or sometimes avoid federal taxes when upgrading their art work to more elite and marketable artist names.
The exchange tactic essentially enables an investor to defer paying 28 percent capital gains tax on sales of art and other collectibles, such as stamps and coins, by applying the profits from one work toward the purchase of a similar one. Some liken the process to a no-interest loan from the government in which the investor has access to the money saved for a period of time until the asset is sold. Two strategies that have made the tax break an attractive tool for art investors in estate planning in which they can avoid capital gains taxes include holding the art work bought with money from a previous sale until they pass away or donating it to a museum.
The use of the tax break has significantly grown in response to soaring prices for art and the increasing number of savvy investors, often from the real estate industry or Wall Street, who tend to view paintings and sculptures as "tradable commodities[,]" according to experts.
The Obama administration has taken notice and is seeking to eliminate the tax break for exchanges of art and other collectibles, which has undoubtedly spread alarm throughout the art world. The current administration's focus on 1031 exchanges suggests that a sizable amount of tax revenue is at stake.
Opponents of like-kind exchanges assert that such exchanges were initially intended to avoid the penalization of tax payers whose economic position did not change when assets were exchanged. Opponents view the exchanges as sophisticated "tax dodges" exploited by investors that were never intended to be a tax tool for affluent art buyers.
On the other hand, proponents of the exchanges say the re-channeling of profits into new investments helps the economy with the promotion of growth and job creation. Specifically, exchanges stimulate activity for art auction houses, art galleries, and their commissions, as well as financial professionals (CPAs, etc.) and art shippers – a lot of people upstream and downstream who are ordinary working people. Proponents assert that the 1031 exchanges are based on the principle that it is unfair to tax a "paper" gain, if an investor is simply selling an asset and is quickly reinvesting the profits into the same kind of activity.
It is estimated that the elimination of 1031 exchanges could in some situations reduce gross domestic product by about $8 billion annually, according to an Ernst & Young economic study for the Federation of Exchange Accommodators.
The use of the tax break is expected to continue to grow while the art market remains confident and steady, and where buyers purchase art as an investment, not for aesthetic pleasure, according to experts. It will be interesting to see what the future holds for 1031 exchanges and the use of same by art investors in the next few years.
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