A recent proposal by President Obama regarding a section of the tax code may have important consequences for art investors.

“Like-Kind Exchanges”

According to the IRS, Internal Revenue Code Section 1031 allows a tax mechanism called a “like-kind exchange.”  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 the section’s detailed 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.”  If the section’s requirements are met, then the IRS essentially treats the entire transaction as a reinvestment of capital, and defers payment of the tax on any gain from the disposed-of property.

The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.  More complex variations include “deferred” exchanges (in which the taxpayer disposes of property and within a short time frame acquires other like-kind replacement property) and “reverse” exchanges (in which the taxpayer acquires replacement property through an exchange accommodation titleholder and then within a 180-day period disposes of other relinquished property to close the exchange).  Like-kind exchanges may be possible even if the seller will also receive cash or other proceeds that are not like-kind property at the conclusion of an exchange; in such cases, the transaction can still qualify as a like-kind exchange, and gains will be taxable only to the extent of the proceeds that are not like-kind property.

In a 1031 exchange, the tax due on the gain is not completely forgiven; rather, when the replacement property is someday sold, the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.  (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.)  The IRS provides rules for how taxpayers should calculate the basis of the property acquired, but generally, the resulting depreciable basis is often lower than what it would be if the replacement property were acquired in a taxable transaction.  A taxpayer can receive additional postponements as long as qualifying exchanges continue to occur.

Section 1031 For Art Transactions

The like-kind exchange has often been used by real-estate investors, but in recent years, as the art market has become a more active arena for investment and prices have skyrocketed, more savvy investors have used Section 1031 like-kind exchanges to defer tax liability in art transactions.  Under the existing rules, an art investor may exchange one like-kind piece of art for another and defer some or all of the tax that might otherwise be due on the gain.

As one commentator recently explained, the current rules can present unique challenges for art investments.  For example, Section 1031 requires that both properties in an exchange be held for use in a trade or business or for investment (as distinguished from property held primarily for personal use).  Thus, a taxpayer seeking the tax benefits of a like-kind exchange of art must be able to show that he or she is not merely a collector but an investor in art, and that he or she owns the art not simply for personal enjoyment but to make a profit.  Moreover, the IRS has not provided specific guidance about what constitutes “like-kind” when it comes to art (for example, exchanging a painting for a sculpture may carry the risk that the IRS might not find the two works to be truly of “like kind”).  Tax experts can offer guidance on how best to handle art transactions so as to qualify for Section 1031 tax treatment under the current rules.

Pending Proposal Would Make Art Transactions Ineligible for Like-Kind Exchanges

President Obama recently has proposed changes that would put an end to like-kind exchanges for art transactions.  Earlier this month, the U.S. Treasury Department released its explanations of the Obama Administration’s revenue proposals for Fiscal Year 2016, including one proposal that would limit the amount of capital gain deferred from an exchange of real property to $1 million (indexed for inflation) per taxpayer per taxable year.  The most noteworthy change for our purposes, however, is a proposal that would render art and collectibles totally ineligible for like-kind exchanges completed after December 31, 2015.

If this proposal were to become law, it could have major ramifications in the art market.  Without the more favorable tax treatment of a like-kind exchange, artworks would become a less attractive investment vehicle.  Early signs suggest that the proposal may face an uphill battle for support in Congress; proposals that would have limited or eliminated Section 1031 exchanges failed last year, and a competing tax reform proposal released in December 2014 by Republican staff of the Senate Finance Committee does not mention Section 1031 like-kind exchanges.  But, as one observer put it, there has been increased political “noise” about and focus on Section 1031 over the last few years, so it is possible that momentum may gather behind this proposal, and we will continue to monitor closely these developments.