Fellow appraiser Tracey Capes sent me an interesting article from the NY Times which compares the fine art market with the real estate investment under the new tax legislation. The article focuses on 1031 exchanges, and what appears to be a continuation for real estate investment, but not with fine art exchanges.
The NY Times reports
Source: The NY TimesOf the many winners and losers in the overhaul of the tax code, one change makes real estate investors the biggest beneficiaries, while art collectors seem to have drawn the short straw.
Real estate investors were given a gift after Congress voted to maintain what are known as 1031 exchanges, a section in the tax code that allows for property to be sold tax-free as long as the proceeds are used to buy more property. The loophole had been open to others as well, including art collectors, classic car aficionados and franchisees, but not any longer.
Investors whose real estate holdings are comparatively modest — and their heirs — were given an added bonus: The estate tax exemption for couples doubled to $22.4 million, allowing those investors to conceivably pay no tax on their properties, ever. They can use exchanges to buy ever more valuable property, and when they die, all of the capital gains are erased, so their heirs inherit the real estate at whatever it’s worth at the time.
The exchange loophole would appear to help wealthy real estate developers like President Trump, whose fortune is made up of commercial properties, and his son-in-law, Jared Kushner, who also hails from a real estate family.
“People keep rolling it over,” said Christopher Pegg, senior director of wealth planning for California and Nevada at Wells Fargo Private Bank. Investors can continue to take advantage of the exchanges until their death, at which point the capital gains tax is eliminated, he said. “You get that big basis step-up in the sky, and the tax is entirely avoided.”
And the cost for investors to save millions of dollars in taxes? A few thousand dollars in fees to the firm that manages the exchange proceeds.
This preferential treatment is great if you’re a real estate investor. But it’s baffling for anyone else and may be downright infuriating to homeowners in high-tax states who could end up paying more in taxes because of limits placed on their ability to deduct property taxes on their federal income tax.
Take, for example, someone who bought real estate in San Francisco 20 years ago versus someone who bought an equivalent amount of stock in Apple, based nearby in Cupertino. Both assets have appreciated wildly and made a tremendous amount of money for their investors.
But here’s where the investors’ fortunes diverge. If the owner of Apple stock sold it all and put the proceeds into other technology companies, the stock sale would be subject to a capital-gains tax of 20 percent.
If the investor who bought real estate in San Francisco sold the property, the money could be used to buy another property in San Francisco — or anywhere in the country — without the seller’s paying a tax on the appreciated gains in the original property.
“From the I.R.S.’s perspective, the taxpayer gives up property and what they receive is other like-kind property,” said Matthew K. Scheriff, a certified public accountant and executive vice president of Legal 1031 Exchange Services. “Why that should apply to real estate and not other property? Obviously, real estate received a little bit of a favorable outcome on that side of the tax package.”
Favorable, indeed.
Combine those tax-free gains with the higher estate tax exemption, and it is possible that a real estate investor would never have to pay capital gains or estate tax on tens of millions of dollars in real estate. If, at the investor’s death, the assets totaled less than the $22.4 million exemption for a couple, decades of embedded gains would be erased.
Moreover, any property tax the investor paid over the years would have been deducted as a business expense — even though the deduction for property taxes for a homeowner has been capped at $10,000.
Clever investors could even sell the properties tax-free. Mr. Scheriff, who completed about 400 exchanges for his clients last year, gave this example: A person sells a building in New York for $1 million and uses 1031 exchanges to buy two rental houses on a golf course in Florida. A few years later, the investor evicts one tenant and moves into the house. After a few years, the investor sells it and claims the personal residence exemption, then repeats the process with the second home.
There are some residency requirements, but if handled the correct way, the strategy produces tax-free gains to be enjoyed in the investor’s lifetime — gains that would be taxed if they were from other investments.
Why is this allowed? “It’s a result of tax law inertia,” Mr. Pegg said. He pointed to the history of farmers swapping odd parcels of land to create contiguous farms that were easier to maintain.
In the last major tax overhaul, which occurred in 1986, a provision in the code allowed for a delay of 180 days between selling one property and buying another, without any tax on the gains from the sale of the first property. A ruling from the I.R.S. also allows people to do “reverse exchanges” — buying a property first and then picking other properties of equal value to sell without paying tax.
Today, 1031 exchanges can turn air into a McDonald’s on Long Island, tax-free. Peter E. Buell, a partner at Marcum, the national accounting firm, said that one of his clients had sold the air rights over a three-story building on 125th Street in Harlem that he had owned for decades. Without doing a 1031 exchange, the client would have had to pay tax on the entire sale price. To avoid paying tax, the client used the proceeds to buy the land on which a McDonald’s sits.
“He’ll collect his rent check for what was air rights,” Mr. Buell said.
In keeping these exchanges just for real estate, lawmakers may have inadvertently signed a decree that will send some museum-worthy pieces of art outside the country.
Top collectors, who may spend millions of dollars for a single work of art, have taken advantage of 1031 exchanges that allowed them to use sales from their collection to buy new art — and save the nearly 30 percent tax on the gains.
But that stopped with the new law. Michael Kosnitzky, a partner at the law firm Pillsbury Winthrop Shaw Pittman, said American art collectors could lose their advantage over those in the Middle East and elsewhere in Asia, who have been buying big-ticket works like Leonardo da Vinci’s “Salvator Mundi,” which sold for $450 million to a Saudi prince who did not have the same tax concerns.
“This is really bad for U.S. collectors,” Mr. Kosnitzky said. And, he said, it is a potential blow for museums in the United States.
“When Steven Cohen or Steve Wynn or another significant U.S. investor — and there are only a handful of them — buys a piece of art, they’re often going to place their artwork in U.S. museums,” Mr. Kosnitzky said.
“Now, those works are going to be out of the U.S. because of that tax law change,” he added. “Or they’ll be kept in private collections where no one will be able to see them unless you know the Saudi prince or the Malaysian billionaire. That’s not cool.”
William J. Kambas, a partner at Withersworldwide, a law firm that was particularly active in doing 1031 exchanges for art, hopes buyers’ passion for collecting overrides their tax concerns. “I think many collectors, with or without the tax benefit, are going to buy and sell art,” he said. “But maybe a piece that someone had to reach for, it might be difficult.”
One thing he is certain of: “This is a boon for those in real estate.”
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