1031 exchanges can benefit art investors

A bill that was introduced in Congress on December 15 would require large auction houses to pay royalties of 7 percent when selling pieces of art that have a value exceeding $10,000. The Equity for Visual Artists Act of 2011 (EVAA) is being proposed by Senator Herb Kohl (D-WI) and Congressman Jerrold Nadler (D-NY), according to Gallerist NY. Various organizations including  Artists Rights Society and  Visual Artists and Galleries Association have expressed their support for the proposal, The New York Times reports. The legislation is based on similar laws, referred to as droit de suite, which have already been implemented in a multitude of countries.

The fees collected would be split between nonprofit art museums and the artists responsible for the works sold. If approved, the new fees could be significant to the art market as the charges could be passed on to investors.

The only auction houses that would need to pay the fees would be ones that claim revenue of at least $25 million. Online auction operators such as eBay would be exempt, The Los Angeles Times reports.

According to The New York Times, the motivation for proposing the legislation largely came from auction houses might be unfairly benefiting from the appreciation that can occur after an artist dies. The legislation comes amid legal disputes that are currently happening between auction houses and artists, Gallerist NY reports. Many artists are contending that the institutions involved owe them money under existing California law, although certain experts have provided their opinion that the state laws are unconstitutional.

"Visual artists deserve a share in the sales and resales of their creative works," Nadler said in a statement, according to The Art Newspaper. "It’s important to ensure that artists are fairly compensated — even more so in difficult economic times, when normal channels of support for artists are less dependable. This legislation would help working artists and provide incentives for the creation of art by providing resale royalty rights and establishing a fund for nonprofit art museums to buy art from those artists."

Individuals who wish to buy and sell artwork can realize tax benefits by setting up a 1031 exchange with a qualified intermediary such as Strategic Property Exchanges, LLC. Deferral of taxation would be the primary benefit derived from setting up one of these transactions. Not having to pay income taxes would allow the investor to retain all the equity they originally had.

Keeping all the equity held in the investment would reduce the debt needed for purchasing the replacement artwork. This reduction in leverage would decrease debt payments and also interest costs. Since debt payments are made out of operating income, which can be taxed at rates as high as 40 percent, lowering debt means reducing taxes.

To provide an example, let’s say that an investor owns a piece of art worth $1 million and wants to sell it. The investor finds a replacement item that will qualify as part of a like-kind exchange. He finds a buyer for his art, and then works with a qualified intermediary to set up a 1031 exchange on the sale. He avoids paying income taxes on the item sold, and retains all equity in the original item.

One final benefit of using 1031 exchanges is that there is no limit on the number of times they can be used. An individual who owns pieces of art such as these can take advantage of market opportunities as many times as he deems it profitable and worthwhile.