Proposed Tax Plan May Do Away With Like-Kind Exchanges For Artwork
11/03/2017Back in 2015, during the Obama Administration, we wrote about a tax proposal that could have eliminated a federal tax code mechanism frequently used by art investors to defer tax consequences from art transactions. Ultimately, that proposal did not become law. But now, a recently-released tax plan offered by Congressional Republicans could put the same mechanism back on the chopping block, at least in terms of art deals. And if the plan becomes law, this change could have major implications for the high-end art market.
Under the existing tax regime, art investors are eligible to take advantage of Section 1031 of the Internal Revenue Code, which governs “like-kind exchanges” of property. Our previous post on this topic contains more detail, but as a brief overview, when a taxpayer sells investment property and has a gain, he or she must generally pay tax on that gain at the time of sale. Section 1031 creates an exception to that general rule; by complying with certain requirements, a taxpayer can postpone paying tax on the gain as long as the proceeds are reinvested in similar property in a qualified “like-kind exchange.” Like-kind exchanges can vary in terms of timing and structure, but if all Section 1031 requirements are met, the upshot is that the taxes due on the gain, while not completely forgiven, can be postponed; when the replacement property is eventually sold, only then would the taxpayer owe taxes on the original deferred gain, plus any additional gain realized since the purchase of the replacement property. And a taxpayer can receive additional postponements as long as qualifying exchanges continue to occur. (In the case of an individual taxpayer, once the owner of the exchanged property dies, estate taxes may come into play, but capital-gains taxes will no longer be owed.)
Section 1031’s Current Application To Art Transactions
Currently, Section 1031 is most often associated with real estate deals. But it can also be applied in like-kind exchanges of other kinds of property, including art. And in recent years, as the high end of the art market has become an attractive arena for investment, savvy investors have increasingly used Section 1031 to postpone tax liability in art transactions; by exchanging one like-kind piece of art for another, an investor can defer some or all of the tax that might otherwise have been due on the gain from the disposed-of piece. (It’s worth noting that under the existing rules, like-kind exchanges are not available to a casual art collector; the tax code requires that both properties in an exchange be held for use in a trade or business or for investment, not merely for personal enjoyment. We should also note that this article is intended only as an overview of the current state of affairs; a tax expert can provide more specific guidance on how best to handle art transactions so as to qualify for Section 1031 tax treatment under the current rules.)
GOP Proposal Would Make Art Transactions Ineligible for Like-Kind Exchanges
This week, the Republican-led Ways and Means Committee of the House of Representatives released a broad-ranging tax reform proposal. Among the possible changes to the tax code is one of particular relevance here: the plan contemplates the elimination of like-kind exchanges for any type of property other than real estate. In other words, should this proposal become law, art and collectibles would no longer be eligible for Section 1031 like-kind exchanges.
Such a change could have a ripple effect in the art market; without the beneficial tax treatment of a like-kind exchange, investors may find artworks to be a less attractive investment vehicle. That, in turn, might lower demand (and prices) for high-end artworks.
This newly-advanced tax proposal may, of course, be subject to substantial debate and revision before it becomes law. And in the meantime, it’s possible that there may be an uptick in art dealmaking as investors seek to take advantage of Section 1031 before they lose their chance. (If the proposal passes, it would go into effect at the end of 2017, although there would be a short transition window in which like-kind exchanges begun before the new year could be completed.) Anyone with interest in the art investment arena should keep a close eye on this proposed legislation as it moves forward.
(And a brief post-script: The GOP tax plan also contains another reform that could have an impact on some art collectors. The proposal would tighten the requirements that a taxpayer would have to meet in order to have his or her art collection treated as a “private museum.” The move reflects legislators’ concerns that some collectors are obtaining tax benefits from such arrangements while giving the public very little actual access to the collections. This potential change could impact some high-end collectors’ tax planning interests and should be watched.)
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