One of the most underappreciated aspects of art collecting and investing is the tax work, which is why we’ve covered the very topic before. And this time, we’re taking a closer look at Section 1031 of the Internal Revenue Code, a loophole that has allowed art investors to bypass paying huge capital gains taxes on properties sold by using a “1031 Exchange,” but with art no longer being accepted as a suitable property, what does this mean for the art market?
Capital gains taxes apply to properties that increase in value over the years. When the investor chooses to sell that property, they’ll need to surrender 38.1% of the sale as part of federal taxes – unless they reinvest the money into a “like-kind” exchange, which is also referred to as a 1031 exchange. To explain it further, if you sell a house that has gained value over the years, 1031 allows you to defer paying capital gains taxes if you use all proceeds of the sale to buy another house. Due to the fact that the IRS was never really clear on what “like-kind” means, people used this to avoid paying capital gains on many different types of property.
Another important aspect of applying Section 1031 is to identify yourself as an investor and not a collector, which has been key for people who have used art as a 1031 exchange in the past. This would mean having your art collection regularly appraised by professionals. Another common route for Investors would be frequently lending their artworks to museums for extended periods of time, which would drive up the value of said art. While there’s technically no single behavior to differentiate investors from just collectors, you can read what Artsy recommended in the past, which of course is all for naught today. This is mainly because only art investors, and not collectors, can take advantage of Section 1031 exchanges. If you wanted to defer paying the capital gains tax by selling artworks, it was crucial to treat your collection as an investment.
As previously stated, plenty of art investors have taken advantage of the 1031 tax loophole since its inception in 1921. By exchanging paintings for paintings and sculptures for sculptures, in the same way that a real estate investor would exchange a building for a similar building, investors were able to foster quick turnarounds in both the art and real estate industries. However, the recent tax reforms by the current administration put a stop to this practice. As per the latest reforms, artworks can no longer be used for “like-kind” or Section 1031 exchanges – which is bad news for new art investors just getting into the game.
The frequently changing nature of tax reforms are notorious for making life difficult for new buyers. In real estate, this is highly evident in one of the most expensive places to live on the planet, in the form of New York City. The NYC tax reforms page on Yoreevo reveals how most people who can afford to buy a home in New York can’t deduct property taxes: “Following the recent tax changes, the maximum deduction for state, local and property taxes is $10,000. Once a New York City resident’s income hits about $110,000, his or her state and local tax bill is $10,000.” Unfortunately, such changes in federal tax codes are a constant in any taxable industry.
As the old adage goes, the only sure things that you can expect in life are death and taxes. For art investors this means you need to get used to dealing with, and being fully updated on, the next new tax reforms. The banning of artworks in a Section 1031 exchange is just one of the many recent legal shifts that you need to be aware of, and there are likely to be similar changes in the near future. Just remember that the reforms that apply to real estate investments usually also apply to similarly-priced investments such as expensive artworks.