Art Market Rocket Fuel

More art market participants than ever before now use a special tax strategy that enables them to defer paying capital gains taxes on the sale of art,making it an ever-more-important factor fueling art market turnover, especially for very expensive works of art. I call it the art market's "rocket fuel."

Unfortunately for art buyers, this tax strategy recently attracted the attention of the US House of Representatives, which in early November proposed its elimination in the Tax Cuts and Jobs Act. But observers have predicted the demise of this special tax preference for art for the past 20 years, only to see it remain steadfastly in the tax code. What follows is an explanation of how the tax strategy works, and who is eligible to use it, followed by a discussion of what its repeal could mean for the art market.     

ARE YOU A COLLECTOR OR AN ART INVESTOR?

Suppose many years ago a collector fell in love with a painting, bought it for $10,000, and hung it in her living room. Since then, the artist’s career has taken off, and the painting is now worth $400,000. Lucky collector. Now, she wants to sell it and use the proceeds to buy different artwork that is more consistent with her current tastes.

From the perspective of the government, selling the painting is a taxable event. Since the painting was held for more than one year, the collector needs to pay long- term capital gains tax on the $390,000 gain in value. At the federal level, the collector may have to pay a combined 31.8 percent tax on the gain (equal to the 28 percent capital gains tax on art plus the 3.8 percent Affordable Care Act surcharge on investment income), leaving her with $276,000 after taxes to buy art.  The story ends there for collectors.

But suppose the facts and circumstances change so that the owner of the painting held it for investment purposes. Then it may be possible to defer paying capital gains taxes on the sale and have $400,000 to spend on art.

The key is Section 1031 of the Internal Revenue Code. When an investor sells property that has increased in value, such as an apartment building, she  pay capital gains taxes in the year of the sale. But Section 1031 permits investors to defer paying the tax if they reinvest the proceeds in similar, like-kind property, i.e., another apartment building. Section 1031 Exchanges, also called Like-Kind Exchanges, have been part of the tax code for over 90 years, and are frequently used by real estate investors. Investors in art can potentially use the 1031 exemption to defer paying capital gains taxes on a sale if they reinvest the proceeds in like -kind art. The Internal Revenue Service has provided little specific guidance on what “like -kind” means for artworks. Tax advisors, as a result, tend to advise clients to exchange paintings for paintings, sculpture for sculpture, and drawings for drawings.

Art Basel Miami Beach (2015). 

Art Basel Miami Beach (2015). 

Well then, what defines an "art investor," a title that many collectors are probably loathe to publicly claim? This is the critical question, because only investors can take advantage of 1031 Exchanges. There is no single fact or behavior that categorically determines whether someone is an investor. If the owner never sold anything meaningful from her collection and she displayed the artwork prominently in her home, then the IRS will most likely view her as a collector, not an investor. Investors own art principally to earn a profit, rather than for personal enjoyment.

Tax advisors believe the IRS will view taxpayers more favorably as investors if they have regular collection appraisals done by professionals; take steps to increase the value of the collection by, for example, lending works to museums; keep detailed records of purchases and sales; seek advice from art experts; and present themselves to galleries and auction houses as art investors. The rules and regulations around like-kind exchanges are complex and need to be followed assiduously with input from a qualified tax advisor. 

WHAT HAPPENS IF ART IS NO LONGER ELIGIBLE FOR 1031 EXCHANGES?

Because the purchase and sale is not a taxable event for art buyers with an investor designation, they are much more willing to trade than would be the case if the transactions were taxable. The availability of 1031 Exchanges for art has been a very important factor fueling art market turnover. It is not uncommon for many lots in the important evening sale auctions to be linked to a like-kind exchange.

Like-kind exchanges can also magnify turnover, as shown in the following real-life example. Earlier this decade, a financially-driven collector who wishes to remain anonymous sold at auction a wonderful painting by a well-known American artist for $8 million. Because he purchased the painting for a fraction of that sale price many years ago, he had a huge potential capital gains tax liability. Knowing this would be the case, he worked with his tax advisor to make the sale part of a like-kind exchange. Within 2 months of selling the painting, he purchased $8 million of art with the sale proceeds, which enabled him to defer the capital gains tax liability. What is fascinating about this case is that the person who bought the painting for $8 million, also set up a like-kind exchange with their tax advisor. Within 3 months of buying the painting, he sold $8 million of appreciated art to finance his purchase, enabling him to also defer paying capital gains tax on his appreciated art. The initial sale of the $8 million painting led to an additional $16 million of turnover. In just this one iteration alone, there were actually three transaction sets and $24 million of sales spurred by the like-kind exchange policy.

While the House of Representatives tax bill eliminates the use of 1031 exchanges for art (but preserves it for real estate investors), it faces, like most legislation, a long and winding road to passage. But if art is no longer eligible for 1031 Exchanges, then many art market participants subject to U.S. law will likely elect to hold their art for longer time periods, causing a noticeable decline in art market turnover.       


Doug Woodham is the Managing Partner of Art Fiduciary Advisors, an advisory practice based in New York City that helps clients create legacy plans for their art collections. The firm offers comprehensive services, from clarifying family goals and evaluating alternative disposition strategies, through the execution of donation and sale agreements. The firm also advises collectors, artists, and institutions on the sale of art so they can be assured of maximizing sale proceeds in a very complex and opaque art marketplace. Earlier in his career, Doug was President of Christie’s for the Americas and a Partner with McKinsey & Company. He is also the author of the best-selling book Art Collecting Today: Market Insights for Everyone Passionate About Art (2017).