The art world reacted with apprehension to the news last week that a proposed change to US tax law could eliminate a popular tool for some investors. Under the Tax Cuts and Jobs Act passed by the US House of Representatives, the existing Section 1031—governing so-called “like-kind” exchanges used by investors to defer payment on capital gains—would be limited to “real property”, or real estate, from 1 January 2018, if passed by Congress in its current form.
Because capital gains on art are taxed at 28%, rather than the 20% rate on wealth, securities, and bonds, 1031 or like-kind exchanges have become a vehicle for buyers and sellers to trade artworks without incurring tax. An expert, if niche, specialty of art law and tax advisors has risen up to assist, with Deloitte, U.S. Trust, and boutique firms offering services cater to these blue-chip investors, managing and monitoring exchanges either individually or as part of a portfolio.
“The amount of 1031 exchanges has just skyrocketed, and it has become really a driver in the [art] market”, confirms Evan Beard, National Art Services Executive at U.S. Trust. “That going away will have a slightly negative impact on that segment over the long-term.” However, Beard believes the shift will be less dramatic than some may fear. “You’ll still have mega-collectors”, he says. “What may happen is that they may become slightly less dynamic in their art collecting. They may sell less on the way up.”
Diana Wierbicki, partner and global head of art law and Amanda Rottermund, an associate at Withers WorldWide specializing in art law, with specific expertise in fine art as collateral, high-net-worth individuals, and tax, trust and estate planning, offer an explainer.
The Art Newspaper: What exactly is a 1031 like-kind exchange?
Like-kind exchanges are codified under Section 1031 of the Internal Revenue Code. Section 1031 provides for the deferral of capital gains tax on property held for investment when such property is exchanged solely for like kind property also to be held for investment.
How do they work?
1031 exchanges can be structured differently. The general concept requires that investors enter into arrangements whereby the proceeds from a sale of a work of art are parked with a qualified intermediary, who is then instructed by the investor to use the sale proceeds to acquire replacement art.
For example, an investor sells art through a gallery, the gallery sends the sale proceeds to the investor's qualified intermediary, and then the investor identifies replacement art and instructs the qualified intermediary to acquire it using the sale proceeds from the relinquished art. These 1031 exchanges are subject to timing restrictions that mandate how soon after the art sale the investor must identify the replacement property (generally a 45-day timeline that needs to be addressed) and how long the qualified intermediary has to go out and acquire such replacement property (generally a 180-day timeline that needs to be addressed).
Why exclude art from these transactions now?
Collecting additional taxes on capital gains offsets reductions elsewhere in the tax bill. Preserving the use of 1031s to apply only to "real property" shows the power of the real estate lobby.
Art collectors with valuable holdings must also contend with estate tax; the House bill proposes a phase-out. Which is of greater concern for the liquidity of the art market, estate taxes or capital gains on art sales?
Both are of great concern. If there will be no way to defer high capital gains tax on works of art then there will be less incentive to sell. If there will be no estate tax, then there will be no pressure on estates to liquidate art assets to pay for the estate tax.
Is there consensus in the art world about the potential impact of such a change?
There are fears among collectors that the new law will slow down the art market in 2018. If 1031 exchanges can no longer be used on art sales, there is a fear that the capital gains tax that will be owed on a sale may dissuade potential sellers from bringing works to market.
Have clients been approaching you about sales before tax reforms are enacted?
For anyone who is thinking about selling art, the proposed bill is a concern, and has definitely brought their sale considerations to the forefront. Clients are thoughtfully reviewing their own personal facts and circumstances to determine whether it makes investment sense, given the art they currently own, to make any final sales under the current tax regime before any changes are implemented.