The Art (and Law) of Tax-Free Exchanges of Art and Collectibles

06/10/2015 04:37 pm ET | Updated Jun 09, 2016

Tax-free exchanges of art and other collectibles have become fairly common. Some people worry that tax-free exchanges of art provide a safe haven for the wealthy to engage in wealth-preserving activities that are not available to the general population. If such concerns are true, the media has identified an aspect of the tax system that contributes to wealth inequality, and lawmakers should seriously consider who benefits from such exchanges. Owners of art and collectibles should also be concerned, however, because many such transactions may not satisfy the technical requirements of the tax law. Owners of art and collectibles must tread carefully when claiming tax-free treatment on the transfer of such property. The law governing tax-free exchanges of art and collectibles is a veritable minefield, and the slightest foot-fault with such transactions could result in significant amounts of tax.

Tax-free exchanges are often referred to as 1031 exchanges because section 1031 of the Internal Revenue Code provides the basis for tax-free treatment of certain exchanges. Section 1031 provides that a transaction must satisfy at least three requirements to qualify for tax-free treatment: (1) the transaction must be an exchange, (2) the property transferred and the property received must be like kind, and (3) the both properties must be either business-use or investment properties. The law relating to each of these requirements is undeveloped, so many people claiming tax-free treatment of art transactions do so at the risk of losing that treatment. Other discussions provide a more detailed analysis of the law; this article provides a general overview of areas of uncertainty.

The Exchange Requirement

For section 1031 to apply, a transaction must be an exchange. That means that the person transferring a piece of art must receive art, not money, in exchange for the transferred property. The exchange requirement does not, however, require a direct exchange with a single person. The section 1031 rules allow a person to transfer relinquished property to one person and acquire replacement property from another person as part of somewhat complex regulated structure that generally includes a qualified intermediary. The rules regulating such multiple-party transactions are based upon real estate transactions, so they refer to purchase-sale agreements and contemplate traditional real estate closings. Because many art transfers occur at auction and lack purchase-sale agreements and traditional closings, the application of the rules to art exchanges is not intuitive. Unless the sale of relinquished art and the acquisition of replacement art are carefully planned, the two transactions may not satisfy the exchange requirement.

The Like-Kind Requirement

The definition of like-kind property is nebulous, at best, providing that the like-kind requirement has reference to the nature or character of property, not its grade or quality. Because those terms are so uncertain, a person can only be confident that two properties are like kind if there is a specific rule or regulation that identifies them as such. With almost no rules or regulations relating to the definition of like-kind art, a person generally cannot be certain that two pieces of art are like kind. For instance, questions arise as to whether a painting is like kind to a sculpture or a drawing. Under current law, one simply cannot know with certainty whether two pieces of art are like kind.

The Business-Use or Investment Requirement

Perhaps the most difficult requirement for most art owners to satisfy is the requirement to hold art for business-use or investment. This requirement will be difficult to satisfy because the courts have generally held that most people hold art for personal use. The threshold for establishing business-use or investment intent is quite high, and many art owners may find it difficult to satisfy this requirement. Studying art, visiting museums, attending auctions, and holding art in temperature and humidity controlled rooms most likely will not suffice to satisfy the requirement.

The lack of guidance in this area suggests that the IRS has not been active in auditing art exchanges. The media's high-profile coverage of art exchanges may, however, tip the IRS off to them, and the IRS's focus could turn toward art exchanges. With the law being uncertain in this area, perhaps the IRS will begin to look for exchanges that they wish to challenge as a potential source of additional tax revenue. With the heightened scrutiny, owners of art should definitely be sure to dot their "i"s and cross their "t"s on their art transactions to ensure that they satisfy the basic requirements of section 1031. They should also be aware that due to the uncertainty in this area of the law many such transactions may not qualify for section 1031 treatment, and a future IRS audit may deny them tax-free treatment.