The Art of the 1031 Exchange: Rules You Need to Know as an Art Investor
The modern and contemporary art market is booming, and so is a previously little-known section of the U.S. tax code that governs tax-deferred exchanges of property known as “1031 exchanges.” Investors who execute a qualifying 1031 exchange are able to swap one piece of investment property for another, more expensive one without paying capital gains tax at the time of exchange.
When 1031s were added to the tax code in the 1920s, they applied mostly to farmland and other investment real estate. Today, they’re a tool for facilitating more glamorous investment transactions, as some art investors use them to expand and refine their portfolios in an exploding market.
A successful 1031 exchange accomplishes a remarkable feat if you are an art investor, not a collector or dealer, by allowing you to buy more art without immediately paying additional tax: You sell one asset and buy a more expensive one of “like-kind”, and no capital gain tax is due when you make the deal. You can even execute multiple 1031 exchanges using the same series of assets. That means that with the right chain of strategic investments and sales over the course of your life, you can potentially parlay a modest painting into a masterpiece — and defer the recognition of capital gains along the way.
That’s quite a deal, considering that capital gains tax on art sales can be costly (28% federal tax plus a 3.8% Medicare surtax, in addition to state taxes).
Real estate investors have utilized like-kind 1031 exchanges successfully for years, both as an income-tax planning strategy and as part of their overall wealth transfer planning. Now the practice is spreading to the art world, as sales of appreciated art are on the rise.
As 1031s gain popularity among art investors, questions remain about the qualifying use of these exchanges. The legal tests required to execute a 1031 are complex, as are rules and definitions surrounding those tests. Three primary hurdles must be cleared for a successful 1031:
- Your relationship to the pieces involved needs to be as an investor, not a collector or dealer.
- The pieces exchanged need to be of like-kind.
- Time limitations related to the exchange must be met.
1031 Exchange Rules: Are You an Investor or a Collector?
Art investors are eligible for 1031 exchanges, but collectors and dealers are not. To qualify as an investor, you must treat the art as held for investment or income, rather than as part of a personal collection held for pleasure. The determination lies in whether your primary motivation is profit or passion, and that has created confusion for people who view their art as both an investment and an asset that’s enjoyable to own.
“A true investor is more likely to put the works in storage and take them out when he thinks the market has peaked,” says Paul N. Frimmer, a 1031 expert and partner in the Los Angeles office of international law firm Loeb & Loeb LLP. But it’s hard to tell where the IRS will eventually draw the line. As a result, Frimmer says, “most people take the extra effort to demonstrate they are investors of art, not collectors.” This can include photographs of the stored artwork, paperwork and keeping a record of the context of their art investments.
"A true investor is more likely to put the works in storage and take them out when he thinks the market has peaked."
If you’re unsure of your status but interested in pursuing a 1031 exchange, Frimmer recommends building your art-investor bona fides:
- Make sure you buy and sell art rather than just build your collection.
- Consider isolating your investment collection, perhaps by establishing an LLC to oversee the works.
- Deduct the cost of insurance and conservation for your investment art (rules prohibit collectors from doing so).
1031 Exchange Rules: Are the Pieces of Like-Kind?
The rules of the like-kind exchange are somewhat fuzzy, with no definitive guidance from the IRS. There is some consensus that exchanging with the same medium is permissible — you can swap a painting for a painting, for example. It is less likely that you can exchange across media, such as swapping a David Smith painting for one of his sculptures. Suzanne Shier, chief tax strategist at Northern Trust cautions, “the rules relating to what constitutes ‘like-kind personal property’ are considered more restrictive than those pertaining to real estate.”
“We just don’t know; no one knows,” Frimmer says. “We don’t even know whether the IRS plans to add further clarification, because even though the number of high-dollar 1031 exchanges involving art is rising, the sheer number of transactions may not be great enough to get the IRS’s attention.”
Because like-medium art exchanges are considered permissible even when the art comes from different artists, movements or even eras, 1031s are gaining momentum as a legacy-extending wealth transfer-planning tool. For example, if you hope to pass on the family business to someone in the next generation who may not share your interest, you can shift the focus of the business to something that’s more likely to engage your heir. It may be that swapping a Picasso sculpture for one by Jeff Koons is just the ticket to sustain an interest in art investing.
“It’s an opportunity for you to say, ‘More important than the individual pieces, I want to pass on that appreciation of art for investment,'” says Tim Bresnahan, Northern Trust’s associate director of Philanthropic Advisory Services."It's an opportunity for you to say, 'More important than the individual pieces, I want to pass on that appreciation of art for investment.'"
Other Rules Around 1031 Exchanges
One other note on executing a 1031: timing. Simultaneous exchanges are uncommon. If your sale precedes your purchase in the exchange transaction (a “forward exchange”), you’re required to use a qualified intermediary for the 1031 transaction so that you don’t hold the proceeds from the sale of the art you’re selling as part of the exchange transaction. (You have 45 days to identify and 180 days to acquire the replacement art in the transaction during which the intermediary holds the funds from the front half of the swap.) Specialty firms around the country focus on 1031 facilitation.
There have been proposals to preclude use of 1031 exchanges for art. But, at present, there may be opportunities to work within the code to minimize the tax implications of investing in that next great work of art.