Fine Art Like-Kind Exchange

The NY Times is reporting on how high-end art collectors are deferring millions of dollars in taxes by using a like-kind exchange of property.  The process was originally developed in the 1920s to assist farmers, and then moved to real estate investors, and now art collectors.

The concept is when selling a painting to take the roll the proceeds of selling a painting into the purchase of a new painting. In doing so, the capital gains rate of 28% for fine art is deferred.

There is a push to do away with the deferment, but many collectors are voicing their concern about the effects on  the market if like-kind exchanges for art are legislated out of existence.

The NY Times reports on the use of like-kind exchanges for fine art

Introduced in the 1920s to ease the tax burden of farmers who wanted to swap property, it soon became a tool for real estate investors flipping, say, office buildings for shopping malls.

Now, this little-known provision in the tax code, known as a like-kind exchange, has become a popular tactic for a new niche of investors: buyers of high-end art who want to put off — and sometimes completely avoid — federal taxes when upgrading their Diebenkorns for Rothkos.

“You can defer millions of dollars of taxes,” said Josh Baer, an art adviser who helps clients take advantage of the tool.

The exchanges have become prevalent enough, and the cost to the government significant enough, that the Obama administration is seeking to eliminate them, a prospect causing no shortage of alarm in sectors of the art world.

Lawyers in Manhattan are warning clients about what might happen to the market if the provision were yanked, and are facing anxious questions at conferences on the art market. Lawmakers in Washington, meanwhile, are receiving phone calls and letters from the growing corps of like-kind exchange advisers in opposition to eliminating the exchanges.

Experts say the use of the tax break has expanded in response to surging prices for art and the rising number of savvy investors, often veterans of the real estate industry or Wall Street, who have come to view paintings and sculptures as tradable commodities.

“I get calls all the time,” said Stan Freeman, president of Exchange Strategies in Campbell, Calif., one of the companies that help arrange such exchanges. “It’s a function of the marketplace right now.”

In its simplest form, the maneuver allows an investor to delay paying the hefty 28 percent capital gains tax on sales of art and other so-called collectibles, like stamps and coins, by pouring the profits from one work into the purchase of a similar one.

For example, someone who made $10 million on the sale of a Warhol would ordinarily owe the government $2.8 million. But with the exchange, the entire $10 million can be recycled into the purchase of, say, a Gerhard Richter. If the investor holds that painting for a decade or longer before selling, inflation eats away at the effective cost of the $2.8 million bill.

“You have access to the money saved for a number of years, until you decide to sell the asset,” said Thomas C. Danziger, a lawyer in Manhattan who has helped structure such exchanges. “That’s a big benefit. Or you may never pay capital gains if you die before the replacement work is sold.”

Investors can avoid all capital gains taxes by holding the artwork bought with money from a prior sale until they die or by donating it to a museum, two strategies that have made the tax break — also known as a 1031 exchange after the section of the tax code that permits it — an attractive tool in estate planning.

Other investors sell and repurchase a series of works of escalating value without paying tax until an ultimate sale many years down the road, a process that some liken to receiving a no-interest loan from the government.

“If you are doing five transactions over 25 years,” Mr. Baer said, “each time buying something more expensive, each time you don’t pay the capital gains tax on the way. At the end of the day you are way ahead.”

Proponents of the exchanges say rechanneling profits into new investments, whether they are office buildings or sculptures, promotes growth and creates jobs.

“Sometimes I am asked when I am in Washington, ‘Why should we let rich people have this tax break?’ ” said Suzanne Goldstein Baker, a former president of the Federation of Exchange Accommodators and a lawyer with a company that helps investors swap assets. “But these rich people are the same as everyone else. And it stimulates activity for galleries, and their commissions, and auction houses and C.P.A.s and art shippers. You have a lot of people who are upstream and downstream who are ordinary working people.”

But critics say such exchanges were never intended to be a tax tool for wealthy art buyers.

“What we are seeing is yet another sophisticated federal tax avoidance scheme,” said Senator Ron Wyden of Oregon, the ranking Democrat on the Senate Finance Committee. “Some people are exploiting this tax provision as an estate planning tool to help them transfer wealth.”

In its 2016 budget, the Obama administration is proposing to eliminate the tax break for exchanges of art and other collectibles, and to limit it in other cases, like the swapping of real estate parcels. It estimates that the change could bring in $19.5 billion in deferred or avoided taxes over the next 10 years. While federal officials say they do not have a precise breakdown of the tax impact of 1031 exchanges specifically for art, the White House’s attention suggests that a sizable amount of tax revenue is at stake.

Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, said he agreed with the administration’s efforts. Like-kind exchanges, he said, were originally intended to avoid penalizing taxpayers whose economic situation did not change when they swapped assets. Now the exchanges have evolved into tax dodges exploited by investors, he said.

“In these days of concern over income inequality and trying to spread the burden progressively, this particular provision — especially applied to art — would provide a big bang for its buck,” he said.

There is no limit to how many times an investor can delay paying taxes through exchanges. Proponents say the exchanges are based on the principle that it is unfair to tax a “paper” gain if an investor is simply selling an asset, be it farmland or art, and quickly reinvesting the proceeds in the same kind of activity.

Ms. Baker said she arranged exchanges involving several hundred artworks each year, including deals with works by Andy Warhol and Chuck Close. But some of the exchanges include much smaller works, some costing as little as $15,000 — not exactly the pieces usually pursued by major collectors.

A study by Ernst & Young for the exchange federation estimated that eliminating 1031 exchanges could, under some conditions, shrink gross domestic product by about $8 billion annually.

Ms. Baker pointed out that even in circumstances in which no capital gains taxes are collected because investors have died, their heirs would still usually face estate taxes on the fair market value of the art.

Experts on such exchanges said that none of their clients wanted to offer examples of the artworks they had swapped, or to discuss the extent of taxes they had been able to defer.

But in 2013, the names of the parties in an attempted exchange became public when a dispute ended up in court. Jane B. Holzer, a collector who was once a protégée of Warhol, had agreed to sell two works, including “Rainbow Coalition,” a multicolored acrylic by Mike Kelley, for $740,000 and sought to roll some of the undisclosed gain into the purchase of two works by Richard Prince.

To qualify under the tax laws, sellers must abide by the myriad rules that govern 1031 exchanges, among them the directive that the purchase be strictly an investment for business purposes, and not for personal enjoyment — so no hanging the Monet in the dining room.

To avoid taxes, the proceeds from one sale must be rolled into the purchase of a “like-kind” item, a categorization that the Internal Revenue Service has yet to fully define but that most experts advise allows exchanging a painting for another painting, for example, but not a painting for a sculpture. These rules mean that many investors own their artworks via separately established companies and store them in art warehouses away from their homes.

And the exchange, which has to use the help of an independent intermediary, must be completed within 180 days.

Still, the level of the compliance with these rules is unclear. An I.R.S. spokesman, Anthony Burke, said the agency could not say without further study whether there had been any recent enforcement action associated with 1031 exchanges by art investors.

In 2007, the Treasury Department’s inspector general suggested in a report that the tax authorities should do more to enforce compliance.

The administration’s plan is expected to encounter difficulties in Congress. Lawmakers, though, are also considering their own limits to 1031 exchanges. But it is unclear if any change, whether a repeal of art exchanges or limits on real estate ones, will emerge from the broader political battle over tax reform.

Supporters of the exchanges say it does not make sense to eliminate favorable tax treatment for artworks but not for real estate. Single paintings these days can sometimes cost more than the buildings where they hang. Experts say the tax break’s use will continue to grow while the art market remains buoyant, and where buyers purchase art not for aesthetic enjoyment but as an investment.

“Its growth is tied to art being recognized as another asset class and that it should be treated as such,” said Judd B. Grossman, a lawyer who specializes in art cases.

Source: The NY Times