Managing Taxes Means More Art by Stan Freeman

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Stan Freeman, President and Founder of Exchange Strategies, speaks with Tang on how the sale of investment grade works of art can trigger substantial capital gains using 1031 exchanges. In 2005, Freeman and two others founded an independent QI that quickly grew to be among the largest in its category. Mr. Freeman held the position of Executive Vice President of Business Development, where he introduced and implemented many of the concepts and programs that contributed to that rapid growth.  

The sale of investment grade works of art can trigger substantial capital gains. Savvy Investors have successfully deferred the recognition of those gains by using 1031 exchanges. The term “1031 exchange” refers to decades-old Section 1031 of the Internal Revenue Code. It describes a process for exchanging investment assets that results in a deferment of the gain on the sale of one or more “relinquished” assets when similar “replacement” assets are acquired according to the rules provided in the Code. This strategy for maintaining the continuity of capital invested in important asset categories is intended to promote and stimulate economic activity; it is anything but a "loophole".

In a forward art exchange, the Investor would hire a 1031 Accommodator to structure and conduct the transfers of relinquished art to its buyer and to hold the cash proceeds of the sale (for up to 180 days) until replacement art is acquired. In a successful exchange, the gain on the sale of the relinquished art would not be recognized and the cost basis of the relinquished art would be transferred to the replacement art. If relinquished art was purchased for $500,000, for example, and later sold for $1,000,000 as part of a 1031 exchange in which replacement art was purchased for $2,000,000, then the cost basis of the replacement art would be $1,500,000. The taxes - federal, state (usually) and ObamaCare - on the gain ($500,000) resulting from the sale of the relinquished art would not have to be paid at that time and the cash kept "in play" would be considerable. Another mode of exchanging is the reverse 1031 exchange. Simply put, a reverse exchange allows the replacement art to be acquired before the relinquished art is sold. If the replacement art is acquired first, the remaining task is to sell relinquished art, from among the pieces already owned by the Investor, within 180 days if the purchase. Perhaps the most interesting application of the reverse exchange is the increased spontaneity it provides – the ability to buy at auction or through a gallery precisely when a desirable piece becomes available knowing that it can still be included in a 1031 exchange. This means that an Investor can shop both domestic and foreign galleries and auctions in pursuit of important additions without artificial deadline pressure and with confidence that an exchange is still possible.

In addition to the deferral of gain, a state-of-the-art 1031 Accommodator usually can provide a parallel strategy, e.g. a trade-in credit, to reduce or eliminate local sales/use taxes on the purchase of the replacement art. 

Experienced art Investors know that there are other questions regarding the status of art as an investment and whether or not the like-kind requirements in the 1031 code are satisfied for a particular exchange. But, as the gains in the value of world-class art continue their meteoric assent, it's worth the effort to answer those questions and take advantage of the provisions specifically enacted by the Congress for preserving capital - thereby increasing the amount of fine art the world can enjoy.

For more information on 1031 exchanges or other financial structuring queries, please contact us.