Apples and Picassos

“Like-kind” art trades may bring tax benefits, but only if carefully executed.

OUR NEW CLIENT Joe was a Wall Street trader and avid collector
of works on paper. Although not all his trades panned out”
(Iceland didn’t want any submarines because it has no navy),
Joe’s tax bill was still high. When he came to us, he reckoned he
had found the perfect solution: “like-kind exchanges” of his
art under Section 1031 of the Internal Revenue Code, which
he thought would permit him to defer taxes indefinitely while
allowing him to trade his works for other assets. Although
we see many proposed like-kind exchange transactions, those
that are done correctly in the art world are about as rare as
Icelandic admirals—and so it was with trader Joe’s.

His first brainstorm was to swap some Warhol lithographs
he had inherited for a two-bedroom condo in New York’s
Tribeca neighborhood. The art and real estate were both
worth about $2 million, so he presumed the exchange would
have no tax consequences.

Not so, we replied, and gave him a quick 1031 primer.
Art transactions that qualify under Section 1031 allow for
tax deferral—not tax elimination—on capital gains from the
sale of qualified works if the proceeds are reinvested in like-kind
works within a certain statutory period. The rationale is
that one work has merely been swapped for another substantially
similar property, and so taxes should be paid not on the
swap but on the eventual sale of the replacement work.

However, in order to qualify for 1031 treatment, Joe faced
some serious hurdles. First, he would have to prove that he
acquired the art primarily for investment, and not just for
personal use and enjoyment.

The problem for Joe was that he hadn’t bought the Warhols but had inherited them, and
for years they had been decorating his East Hampton house.
To us, the prints seemed to be part of his personal collection,
not acquired and held primarily for investment.

Second, and just as important, Section 1031 speaks of
exchanged property that is like-kind in “nature or character.”
Swapping art for real estate would clearly not qualify
for 1031 treatment. End of story.

“OK, so how about I swap a small Serrano photo for a
17th-century ceramic saucer?” suggested Joe.

Not so fast, we warned him. Neither the IRS nor court
decisions clearly define a like-kind standard for art. On
the one hand, art in different media should qualify for the
exchange since their nature and character as works of art
remain the same. Moreover, since differences in “grade or
quality” do not matter under Section 1031, variations in
artist, medium, style, and value can be viewed as irrelevant
to whether the art qualifies.

On the other hand, in a private-letter ruling issued by the
IRS in 1981 involving a taxpayer who owned a portfolio of
artworks destroyed in a fire, the IRS held that lithographs
may not be replaced with art in other media. However, that
ruling was under a different section of the tax code—Section
1033. Moreover, private-letter rulings (unlike revenue rulings)
are only for the use of the taxpayers to whom they are issued
and may not be relied on by others. Since the standard under
Section 1033 for casualty losses is more restrictive than the
“like-kind standard” under Section 1031, requiring that the
replacement property be “similar or related in service or use” to
the property destroyed, we questioned whether the same result
would apply under Section 1031.
In fact, courts have gone so far as to say that
even different impressions of the same print may not be considered fully
equivalent. In the 1993 case David Tunick, Inc. v. Kornfeld, a New
York federal district court held that because fine art prints are unique,
the buyer of an authentic print with an allegedly forged signature does
not have to accept a replacement print with an authentic signature.
The court observed that “two prints from a series…possess distinctive
qualities that may impact their aesthetic and economic value”
based on the wear of the plate during printing. The case involved a 1935
Picasso print, La minotauromachie, which dealer David Tunick bought
from Swiss auctioneer Eberhard Kornfeld and Galerie Kornfeld und
Cie for $1.68 million. The parties settled out of court in 1994.

Although the Tunick case does not pertain directly to Section 1031
definitions of like-kind property, it does illustrate that constructing
a valid exchange is trickier than Joe (and others) may believe.

We also pointed out that various technical requirements make 1031
exchanges even more complicated. For instance, if the taxpayer were
himself or through an agent to receive the proceeds of the sale of a relinquished
work before a replacement work is acquired, the IRS would
not allow the 1031 transaction. That is why taxpayers making 1031
exchanges use not only experienced attorneys (we hope) and accountants
but also middlemen, called qualified intermediaries (QIs), who hold
proceeds from the sale of the exchange property and pay these proceeds
to the seller of the replacement property. The QI must be an independent
party, which is why we can’t act as the QI for our clients. Generally, the
taxpayer must identify the replacement property within 45 days and
acquire it within 180 days of the date on which the relinquished property
is transferred; otherwise, the IRS will disallow the transaction. In addition,
taxpayers must file an IRS Form 8824 disclosing the transaction.

Joe was undaunted. “Here’s another trade,” he continued. “I want to
replace one Basquiat drawing with another, but since his drawings sell
quickly and inventory is scarce, could I buy the new one before selling
the old one and still defer tax?”

The answer is yes. In 2000, the IRS issued Revenue Procedure 2000-
37, which created a safe harbor for a “reverse 1031 exchange” when
replacement property is purchased prior to closing on the relinquished
property. In a reverse exchange, a separate holding company, referred to
as an exchange accommodation titleholder (EAT), is established to take
title to (or “park”) either the relinquished property or the replacement
property. A parking arrangement is necessary for a reverse exchange
because the IRS does not allow the exchanger to have title to both the
relinquished property and the replacement property at the same time.

“EAT? Park?” asked Joe. “I eat steaks and park my Porsche, but
technical legal requirements give me gas. What’s the worst that could
happen if I just ignored the rules?”

“Jail time,” we replied cheerfully. After all, on the other side of
the table will be the IRS, not some kid on a trading desk in Delhi. We
reminded Joe that the Pop artist Peter Max was indicted in 1996 by a
Federal grand jury on charges that he bartered his paintings as part
payment for homes in Woodstock and Southampton, New York, and
in the U.S. Virgin Islands while failing to declare the “sale” of those
paintings on his income tax returns. Max reportedly pleaded guilty
to charges of conspiracy to defraud the IRS and tax evasion and was
sentenced to two months in prison and a $30,000 fine.

“Many of my closest colleagues went to jail,” shrugged Joe.
Joe ended our meeting by asking about yet another trade: Could he
barter our legal fees for his signed first edition of Liar’s Poker?

We politely declined, saying that we had read the book years ago and
had even gotten a copy for our mother.

“Good trade,” he smirked. Download this article here.