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 pays 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, sculptures for sculptures, and drawings for drawings.
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.