Suppose you are an art investor and want to dispose of a piece of art that you acquired a long time ago that has appreciated substantially in value. If you wish to purchase a replacement work of art with the proceeds of the sale of the piece, the IRS will tax its appreciation in value at the capital gains rate of 28%.[1] Fortunately, the IRS has promulgated regulations by which the art investor may acquire a replacement piece without having to pay any tax. This method is known as a like-kind exchange.[2]
Here’s how it works. Assume that investor, Mr. Smith, wants a painting owned by collector, Ms. Jones, and Ms. Jones wants to acquire Smith’s piece. Assume further that both paintings have equivalent value. In such a case, the IRS will allow Smith and Jones to swap title to their respective paintings and will not impose a tax on either investor.
The exchange can be made even when the exchanged artworks are not of equivalent value. For example, assume that Mr. Jones’ Monet is worth $1.5 million, but Ms. Smith’s Matisse is worth only $1 million. The collectors may still swap their paintings, with Smith also paying Jones $500,000 in cash. In such a case, the cash received by Jones (commonly called “boot” in IRS lingo) is taxed at the 28% capital gains rate, but none of the $1 million dollar portion of either painting is subject to any taxation.[3]
For a like-kind exchange to work, the swapped pieces must be of the same kind, and tax courts and the IRS have strictly interpreted this rule when it comes to art exchanges. For example, a sculpture and a painting are not considered like-kind qualifying property for an exchange, and neither would say a painting and a lithograph. Accordingly, the taxpayer who wants to take advantage of the like-kind exchange provision must be careful in making sure that the exchanged pieces are the “same artistic medium.”[4]
Like-kind exchanges may even be made in circumstances in which investor Smith wants investor’s Jones painting, but investor Jones does not want to take title to Smith’s artwork but wants cash instead. In such an event, a qualifying “exchange agent” may be appointed to facilitate a deferred like-kind exchange.[5] Gallery owners and professional art dealers are considered preferable as exchange agents. In the case stated above, Smith transfers title to his artwork to the exchange agent (the relinquished property) who then sells the relinquished property and uses the sale proceeds to buy Jones’ artwork. Then Jones transfers title of his artwork to Smith. Before the transfer takes place, a qualified USAP professional appraiser must be retained to ascertain, in a formal written appraisal report, the fair market “stated value” of the artwork that Jones transfers to the exchange agent. If the exchange agent sells the relinquished property for more than the stated value as determined in the appraisal report, the excess proceeds of the sale of the relinquished artwork belong to the exchange agent. The catch is that the deferred exchange is time-sensitive to qualify as a tax-free like-kind exchange.[6] Under the regulation for such deferred exchanges, Smith, who transferred his work to the exchange agent, must identify a replacement piece of art to purchase within 45 days and 180 days to close title on the replacement property.[7] Furthermore, the parties to the deferred exchange must file IRS form 8824 that requires the parties state the details of the exchange.
[1] Recall that If you’re an art “collector”, your gain is defined simply as the amount exceeding your basis—“basis” being simply defined as the amount on resale exceeding the original purchase price. However, if you are an art “investor”, “basis” includes not only the original purchase price, but also includes all incidental costs.
[2] Note that the like-kind exchange may only be made between to works of art held for productive use in a trade or business. See IRC § 1031(a)(2). Generally, this provision means that the artwork must have been held by an investor for the purpose of making a profit.
[3] See IRC § 1031(b); see also Coleman v. Commissioner, 180 F2d 758 (8th Cir. 1950).
[4] See Private Letter Ruling 81-27-089.
[5] A person is disqualified as an exchange agent if (1) the proposed exchange agent was already the agent of the taxpayer at the time of the transfer, (2) the proposed exchange agent is related to the tax payer as defined in IRC § 267(b) or IRC § 707(b), or (3) is related to a person who is disqualified pursuant to § 267(b) or IRC § 707(b). Additionally, a person is disqualified as an exchange agent if she acted as the taxpayer’s employee, attorney, accountant, investment banker or broker during the two years immediately preceding the transfer of the relinquished artwork to the exchange agent.
[6] See IRC § 1031(a)(3).
[7] Id.
This article is written for informational purposes only. Please consult with your agents (attorneys, accountants, wealth managers, etc.) before engaging in a like-kind exchange.