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The Art of the Tax-Free Exchange

- June 4, 2018

Michael S. Schwartz, CFP®, AEP®

I apply a multidisciplinary approach to wealth management dovetailed with structured tax planning.

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In the eyes of pop artist Andy Warhol, “Making money is art and working is art and good business is the best art.” It is a profound quote from an artist but it explains why his works explored the relationships between artistic expression and advertising.

But art is also big business.

Actress Baby Jane Holzer, one of Warhol’s film superstars, was an avid art collector. In 2013, it was reported that she wanted to sell two works totaling $740,000 to the Stephan Stoyanov Gallery and use that money to buy two paintings valued at $990,000 from the Gagosian Gallery. It is a simple idea, but with one problem: By selling her paintings, she would incur a hefty capital gains tax in the year of sale. If sold in 2018, net capital gains from the sale of art or other collectibles would be taxed at 28%. If her cost basis was $240,000, a sale at $740,000 would trigger a $500,000 capital gain, and she would owe $140,000 in federal taxes. Who would want to cut that check if it could be legally avoided? Is there an effective way to sell the appreciated artwork to acquire the new paintings and avoid the taxes? After all, good business is the best art.

Leveraging Section 1031 of the tax code, she decided to do a like-kind exchange, also known as a 1031 exchange. Holzer engaged Stephan Stayonov to act as a qualified intermediary in the exchange. He was hired to facilitate the sale and transfer of her two contemporary artworks and in turn allocate the sales proceeds to acquire two other qualified paintings identified by Holzer for her benefit as replacement artworks. In the eyes of the IRS, a 1031 exchange allows you to effectively transform one investment into another without triggering a capital gains tax because there is no constructive receipt of the sales proceeds by the seller.

While these specialized exchanges are normally used for investment property, such as land and office buildings, Holzer or her advisor determined that she could also use them for artwork or other collectibles, provided they were held for investment and not for personal use.

A 1031 exchange alone would not get her off the hook from paying the tax. Generally, she would sell the acquired paintings in the future and be taxed at that time. Loosely speaking, if she had a $240,000 cost basis in the original paintings but pays another $250,000 to acquire new ones, her cost basis would increase to $490,000. If she immediately sold the new ones at the current $990,000 market value, she would have had a $500,000 capital gain: exactly the same as if she had sold her original works.

So, 1031 exchanges do not eliminate the taxes associated with the sale of appreciated capital assets, they just defer them. The benefit of deferring tax is that inflation can whittle away the future tax payment — and the seller can pocket the profits.

There is no limit on how many times a seller can do a 1031 exchange, so she could continue rolling paintings into more valuable ones over time, continue to build her fortune and never pay a penny in taxes. If she were to hold the final paintings until death, and the IRS code remained unchanged, her heirs would receive a step-up in basis, and all capital gain taxes could be avoided. For investors, it serves as a way to keep fortunes in the family — excluding your Uncle Sam. It’s art in its purest form.

For Holzer, using a 1031 exchange seemed to be a brilliant idea, but it did not go through — Stoyanov’s check, that is. The bounced check was proof that the intermediary did not hold the money in escrow, as required by law, and that voided the exchange. Holzer went on to demand $585,000 with damages for breach of contract, breach of fiduciary duty and unjust enrichment. It is an important lesson for anyone thinking of doing a 1031 exchange: Good business is art, but like all art, it requires proper perspective.

Uncle Sam Alters The Will

The original like-kind exchange rule goes back to The United States Revenue Act of 1921, which allowed for investors to exchange securities and non-like-kind property that did not have a “readily realized market value.” The law previously spoke of “investment property” intended to mean real property such as land or buildings but without considering that it could be interpreted as art or other collectibles such as classic or vintage cars. Although that was not the intention, it created a loophole for collectors.

However, this is not so anymore.

The 2018 Tax Cut and Jobs Act, signed into law on December 22, 2017, retains the use of 1031 exchanges exclusively for qualified real estate but not personal property, including digital assets such as cryptocurrencies, intellectual property, precious metals, machinery and equipment, royalties or franchise licenses to name a few and — you guessed it — artwork and collectibles.

The new law creates quite an impact on investors. In May, a monumental work by Jean-Michael Basquiat, Flesh and Spiritsold at auction for $30.7 million. That is the good news for the seller. The bad news is that it was allegedly purchased for just $15,000, and that means an approximate $7.1 million tax bill including the top 20% federal long-term capital gain tax rate and the 3.8% net investment income tax.

What can be done now for sellers of highly appreciated art and collectibles?

Financial engineering can still be effectuated with proper planning, providing tax-deferral for sellers of capital assets. There is a myriad of other pre-sale disposition planning tools — some well-known and others not so well known — that mimic the tax favor of an exchange or can even improve on the tax benefits through the reduction or the elimination of the capital gain tax entirely.

Whether you are looking to sell Leonardo da Vinci’s Salvator Mundi or a 1962 Ferrari 250 GTO, there are alternative planning strategies deeply understood by a limited number of specialized wealth management advisors that can be strategically employed to keep your hard-earned assets in the family.

It’s just good business. And that is the best art of all.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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