LIKE-KIND AND LOVING IT: Art, Automobiles, Airplanes and Wine Collections.

How to Implement a Tax-Free Exchange Under Code § 1031 for
Art, Automobiles, Airplanes and Wine Collections.
(c) 2014
By Joseph B. Darby III, Esq.
Sullivan & Worcester LLP
1 Post Office Square
Boston, MA 02109
[email protected]
(617) 338-2985
Sullivan & Worcester LLP
Tax Briefings 2014
One Post Office Square
Boston MA 02109
May 28, 2014
4:00 -5:45 p.m.
How to Implement a Tax-Free Exchange Under Code § 1031 for
Art, Automobiles, Airplanes and Wine Collections.
Short Summary
This seminar will examine the steps and qualifications necessary to implement a tax-free
exchange of some of the most interesting and valuable tangible assets in the world today,
including fine art, classic or antique automobiles, private airplanes, and even bottles or cases of
rare wines and other fine spirits. Many individuals invest in these “collectibles" precisely
because they have a proven track record of appreciation and return on investment. The purpose
of this seminar is to help collectors understand how to upgrade their collections, and exchange
existing holdings for “like kind” assets, without incurring substantial tax bills. An art collector,
selling an oil painting and investing in a new and more exciting oil painting, can avoid taxes of
up to 40% on the gain that would otherwise be recognized – literally, millions of dollars can be
saved and reinvested tax-free in new art. That is why we entitle this program “Like-Kind and
Loving It!” Please come join us for an entertaining and sophisticated discussion of life, art, and
all the finer things that living well entails, and enjoy a complementary glass of wine afterwards.
Joseph B. Darby III
Joseph B. Darby III, Esq. is a partner in the Boston office of Sullivan & Worcester, LLP, and has
been admitted to the practice of law in Massachusetts since 1979. He concentrates his legal
practice on tax and business law, and advises individuals and business entities on a wide variety
of tax-related matters, including estate planning, wealth preservation, income-tax planning, and
business and real estate transactions. He is recognized as one of the Best Lawyers in America in
the area of tax practice by Best Lawyers®, the oldest and most respected peer-review publication
in the American legal profession.
Mr. Darby is the author of the highly regarded Practical Guide to Mergers, Acquisitions and
Business Sales, published by CCH (formerly Commerce Clearing House), a Wolters Kluwer
business, and he is a recognized authority in the structuring of mergers, acquisitions, business
sales, and related business transactions. He teaches a course entitled Tax Aspects of Buying and
Selling a Business at the Boston University School of Law Graduate Tax Program (GTP), and
similar courses at Boston College School of Law and at Bentley University in the Masters in
Taxation program.
Mr. Darby is also a recognized authority on the taxation of intellectual property, including tax
issues related to the development, licensing and exploitation of intellectual property rights, and
the migration of valuable intellectual property to offshore jurisdictions. He teaches two courses
on taxation of intellectual property at the GTP, the first entitled Taxation of Intellectual Property,
and the second entitled Structuring Intellectual Property Transactions. He was recently named
by American Lawyer Media and Martindale-Hubbell as a “2013 Top Rated Lawyer in
Intellectual Property.”
Mr. Darby has been the recipient of numerous journalism and writing awards, including
recognition as “Tax Writer of the Year” in 2007 and 2011 by Practical International Tax
Strategies, a Thomson Reuters publication. He has authored two books and more than 1,000
articles for such diverse publications as The Tax Lawyer, Worth Magazine, Venture Capital
Magazine, Banker & Tradesman, Mass High Tech, Hemispheres Magazine, Contract
Professional, Trusts & Estates Magazine, The Boston Globe, The Boston Herald, The Boston
Business Journal and The Boston Phoenix.
Mr. Darby was a sports writer in an earlier life, and wrote sports columns for numerous
publications including the Boston Herald, Boston Phoenix, Hemispheres Magazine and
Worcester Magazine. He was honored with the First Place award in the category of Sports
Columns by the New England Press Association in 1990.
Mr. Darby is the editor of an electronic newsletter entitled “Tax and Sports Update,” a fun and
readable tax newsletter that is billed, tongue in cheek, as “The ONLY tax newsletter with an
award-winning sports column!” Contact Mr. Darby at [email protected] if you would like to
receive a complimentary copy of this newsletter.
Mr. Darby has served as pro bono legal counsel to a variety of Boston-area charitable
organizations. He is currently the President and a Director of the Watertown Police Foundation,
an organization whose mission is to support the Watertown Police Department and its officers.
He is a former President of the Boston Police Foundation (2008-2012), and served in a similar
capacity for that organization.
Mr. Darby received his B.S. degree in Mathematics and Political Science, from the University of
Illinois in 1974, with Departmental Honors in Mathematics, Magna Cum Laude, Phi Beta Kappa
and Bronze Plaque (top 1% of graduating class). He graduated with honors from Harvard Law
School in 1978.
Additional biographical information, including copies of numerous articles written by Mr.
Darby, are available at his firm website
How to Implement a Tax-Free Exchange Under Code § 1031 for
Art, Automobiles, Airplanes and Wine Collections.
By Joseph B. Darby III, Esq.
Sullivan & Worcester LLP
1 Post Office Square
Boston, MA 02109
[email protected]
(617) 338-2985
General. A transfer of property in a sale or exchange transaction normally
gives rise to taxable income or gain. Code § 1001. This is true whether the property in question
is tangible or intangible, real property or personal property. However, Congress recognized that
certain types of business and investment assets — notably real estate, which historically has
appreciated economically even while being depreciated for income-tax purposes — would over
time acquire a substantial built-in gain. This, in turn, would place property owners in a position
where they would be forced to bear a high tax cost on the sale or exchange of such property, and
hence the income-tax laws would discourage capital-asset replacement transactions that
otherwise might have a strong economic benefit. This led to the like-kind exchange provisions
set forth in Code §1031, which basically permit taxpayers who are holding business and
investment assets (including real property) to exchange such assets for like-kind property without
recognizing currently the built-in gain.
IRS Animosity. The U.S. Treasury recognizes that Code §1031 costs the
US government a lot of money every year, and so the Treasury tried several times over the years
to have Congress narrow the scope of Code §1031. However, Code §1031 has a strong
constituency, and all such attempts to date have been defeated. The Treasury’s 1989 proposal
was to change the type of property eligible for tax-deferred treatment under Code §1031 from the
current “like-kind” standard to the “similar or related in service or use” standard that applies
under Code §1033. The Code §1033 standard is generally a much more difficult standard to
satisfy, and so this proposed change would have reduced the number of Code §1031 transactions.
In 1989, the House adopted the Treasury’s proposal, but the Senate rejected it and Code §1031
survived with only minor changes. Subsequent rulings by the IRS suggest that it recognizes that
§1031 is not going to be easily repealed, and in fact the IRS has taken notable steps to make
§1031 far more flexible and dynamic, as discussed below.
Multi-Party and Deferred Exchanges. A property owner who wishes to
replace business or investment property with new property can identify a buyer who desires to
acquire the existing property and can identify the replacement property he wishes to acquire, but
rarely is the owner of the replacement property the same person as the buyer of the relinquished
property. Therefore, a multi-party exchange is necessary. For example, A will transfer
Blackacre to B, B will transfer cash to C and C will transfer Whiteacre to A. Commonly, at the
time B wishes to buy Blackacre from A, A has not yet identified the replacement property, but he
is unwilling to sell Blackacre to B in a taxable sale. In those situations, a deferred like-kind
exchange is required. Years ago it was not clear whether such a “deferred” transaction would be
respected as tax-free under §1031, but in 1979 the Ninth Circuit held in Starker v. United States
that a deferred exchange would be tax free if the replacement property were identified within
five years of the transfer of the relinquished property. The Code was then amended in 1984 to
introduce the requirement of a 45-day period after a transfer to identify replacement property (the
“ID Period”) and a 180-day period to acquire the replacement property (the “Exchange Period”).
Recent Developments and Trends.
The IRS has issued detailed regulations interpreting and defining many of
the transactional issues under Code §1031, particularly those affecting multi-party or deferred
like-kind exchanges. The Regulations tend to be surprisingly liberal on many key issues and
provide useful guidance, and so there is likely to be a greater interest than ever before in likekind exchange transactions.
In addition, the IRS has provided clear guidance and “safe harbor”
protection to such exotic transactions as “Reverse Starker” transactions, Rev. Proc. 2000-37,
Tenancy in Common arrangements, Rev. Proc. 2002-22, and even the use of statutory (grantor)
trusts as a mechanism to “fragment” real estate into very specific sizes and values, Rev. Rul.
The IRS has also provided detailed guidance, and has essentially
“blessed,” like-kind exchange programs that allow businesses with large fleets of vehicles to
exchange vehicles on a mass scale and then “match” the “used” vehicles being transferred with
replacement vehicles being acquired, and allow these transactions to qualify as numeous ongoing like-kind exchanges. See Rev. Proc. 2003-39.
To appreciate the significant tax benefit conferred by Code § 1031, it is
useful to begin by examining the tax consequences of a property sale in the absence of this
provision. A sale or other taxable disposition of property, including an exchange of property that
does not qualify as tax-free under §1031 of the Internal Revenue Code of 1986, as amended (the
“Code”), causes recognition of gain (or loss) equal to the excess of the fair-market value of the
proceeds received over the seller’s tax basis in the property. Code §1001.
The character of the income or gain recognized on a disposition of
property depends on the nature of the underlying asset. For example, real estate or tangible
property used in a trade or business, or held for lease, and subject to the allowance for
depreciation, is generally a so-called “§ 1231 asset.” If a §1231 asset is held for more than one
year (the applicable long-term capital gain holding period), it will generate ordinary loss (if there
is a loss on the sale) or long-term capital gain (if there is gain on the sale, but subject to the
depreciation recapture rules and unrecaptured Section 1250 gain rules, described below).
By contrast, property held as inventory and not subject to depreciation,
e.g., real property bought for subdivision or for sale as condominium units, is characterized as
property held for sale in the ordinary course of a trade or business (i.e., inventory), and therefore
the income (or loss) from such sales would be ordinary income (or loss) in character. Code
NOTE: A transaction that meets the requirements for a like-kind
exchange under §1031 is automatically subject to tax deferral under that Code section – whether
the taxpayer wants deferral or not! In general, Code § 1031 defers recognition of both gain and
loss. This can sometimes be a trap, because a taxpayer may be precluded from claiming a loss.
In general, one must always take into account the tax basis is in the applicable property. Be
aware, for example, that property inherited from a parent may have tax basis in excess of value,
in which case a sale (with loss recognition) may be preferable to a tax-free exchange.
Depreciation Recapture.
The Code provides that, on the sale or other disposition of real property,
all depreciation deductions claimed with respect to such property are “recaptured”, which
generally means that the recaptured amount is subject to tax at ordinary income tax rates rather
than capital gains rates. Code §1250(b)(1).
For real estate, there are really two “recapture” amounts. The first
recapture event is the difference between the accelerated depreciation (or cost-recovery)
deductions claimed with respect to the property and the amount of depreciation that would have
been claimed using the straight-line method of cost recovery. For property placed in service in
the early 1980s under the old ACRS system (in effect prior to the effective date of the 1986 Tax
Act), there can be a small to moderate spread between the cumulative ACRS deductions and the
comparative deductions under straight-line depreciation. Since 1986, however, real estate has
been depreciable under the straight-line cost-recovery method and so property placed in service
after 1986 should have no depreciation “recapture.”
Instead, real estate place in service after 1986 is taxed at a “special” tax
rate of 25% on the so-called “unrecaptured Section 1250 gain,” which is basically the amount
that would be subject to “recapture” if the property were not real estate and the carve-out for
straight line depreciation did not exit. Recognizing unrecaptured Section 1250 gain is not quite
as adverse as recognizing regular “recapture” income or gain, because it is taxed at 25% instead
of ordinary rates (now as high as 39.6%), but it is still very expensive if the real estate in
question is highly appreciated. The good news – make that GREAT news – is that all recapture
income and gain and all unrecaptured Section 1250 gain is partially or fully deferred under a
like-kind exchange.
In comparison, tangible personal property that is subject to depreciation is
required, on disposition, to “recapture” as ordinary income all depreciation deductions
previously taken with respect to such property. Code §1245(a)(5). As a practical matter, since
depreciable tangible personal property is usually not sold later at a price in excess of its original
purchase price, this effectively means that the seller will recognize ordinary income in the year
of disposition to the extent that the disposition price exceeds the current tax basis in the property.
Basic Elements of an LKE.
Code §1031(a)(1) reads as follows:
“No gain or loss shall be recognized on the exchange of property held for
productive use in a trade or business or for investment if such property is
exchanged solely for property of like kind which is to be held either for
productive use in a trade or business or for investment.”
Almost every word or phrase in this sentence has important legal implications that will be
addressed in separate sections below.
Like-kind exchange treatment is mandatory for transactions that meet the
requirements of Code §1031. This becomes important in situations where a taxpayer would
actually like to recognize a tax event on the transfer of real property (e.g., because it has a builtin loss). In a loss situation it is often desirable to structure the transaction so that it fails to
qualify for non-recognition treatment under §1031.
Code §1031 can apply to either or both parties in an exchange transaction.
Note that one party can be eligible for §1031 treatment even though the other is not; e.g., in a
deferred like-kind exchange the accommodation party frequently is not eligible for Code §1031
treatment because he does not meet the “held” requirement, discussed below.
“Held for Productive Use in a Trade or Business or for Investment”.
There are two aspects to the “held” requirement, (1) that it be “held”, and
(2) that it be held for “productive use in a trade or business or for investment.”
The “held” requirement means property may not be eligible for Code
§1031 treatment if it is acquired solely to facilitate exchange or otherwise is acquired for
immediate transfer in a second transaction. See Rev. Rul. 75-292 (property acquired in a §1031
transaction and immediately contributed to a corporation under 351 is not “held” for qualified
purpose). In substance, there is an implicit time period for which the property must be held.
In PLR 8429039, the IRS ruled that a minimum holding period of 2 years
would be sufficient to establish that the “held” requirement is satisfied. For situations where
property is held for less than two years, a one-year-and-a-day holding period provides a
relatively compelling argument, since that is the period that qualifies for long-term capital gain
treatment under Code § 1222(3), and so that period should arguably be regarded as such for
purposes of 1031 as well as for capital gain treatment. Note that a holding period of more than
12 months will necessarily result in the sale occurring in at least one tax year following the year
of acquisition.
The minimum holding period sufficient to meet the "held" requirement is
a very interesting issue, because the court cases have held that it is the taxpayer’s intent at the
time of the exchange that is the key issue. That taxpayer intent is to be determined by the facts
and circumstances, and the holding period is just one of the many relevant factors to be taken
into account in that analysis. Goolsby v. Commissioner, April 1, 2010 and Reesink v.
Commissioner, April 23, 2012. It is the taxpayer's subjective intent that is determinative, but in
establishing that subjective intent the IRS and the courts will look at objective factors that either
support or negate the taxpayer's intent to hold the applicable property for the required purposes.
In the Goolsby case, the court determined that the property in question – a
residential property -- was not acquired for investment purposes, based in significant part on the
fact that the taxpayer moved into the property after just two months of ownership. Morover, the
taxpayer sold his current principal residence at approximately the same time as the acquisition.
The “relinquished property” in the erstwhile exchange could not be rented, and no attempts were
made to rent the erstwhile “replacement property.”
By contrast, the taxpayers in Reesink successfully argued that the
“replacement property” in an LKE was held for investment, even though that taxpayers, as in
Goolsby, later moved into the property and converted it into a personal resident. The Reesink
taxpayers distributed numerous rental flyers advertising that the property was available for rent.
The taxpayers then showed the house to various potential renters, and did not attempt to use the
property for personal or recreational use for a significant period prior to moving into the
property. The taxpayers sold their primary residence approximately six months after acquiring
the replacement property in the purported exchange, and did not move into the replacement
property until eight months after the exchange.
As the foregoing cases illustrate, a former residence can be converted to
investment property, and vice versa, based on the use and intentions of the owner. A practical
rule of thumb is to have at least one tax return showing that the real property is held for a
qualifying use (e.g., by claiming depreciation) before you attempt to claim like-kind exchange
treatment. One year of investment or business use would be the absolute minimum, and would
probably be subject to close scrutiny and possible challenge by the IRS; three to four years of
holding the property for an eligible purpose would be a much safer fact pattern.
“For productive use in a trade or business or for investment” means that
the property has to be held for these specific purposes. Thus, personal property, such as a
residence, or property held as inventory, will not qualify under this exception, even if the
property received in exchange is “like-kind.” One significant point is that the determination of
whether property is held for investment or for use in a business often depends on a taxpayer’s
motives at the time a transaction occurs. For example, a former residence can be converted to
investment property, and vice versa, based on the use and intentions of the owner. A practical
rule of thumb is to have at least one tax return showing that the real property is held for a
qualifying use (e.g., by claiming depreciation) before you attempt to claim like-kind exchange
treatment. One year of investment or business use would be the absolute minimum, and would
probably be subject to close scrutiny and possible challenge by the IRS; three to four years of
holding the property for an eligible purpose would be a much safer fact pattern.
A frequent situation where this “held” issue comes up is if a parcel of real
property is held in a pass-through entity, such as a trust or a partnership, and the parties wish to
break up their co-ownership of the parcel of real estate by acquiring other property through the
mechanism of a §1031 exchange. For example, the partners may wish to distribute the real
property to themselves as co-owners, and then do a like-kind exchange whereby one former
partner acquires a new parcel of land in exchange for his former interest in the partnership asset.
However, because of the “held” requirement, such a transaction is risky unless the partnership
asset is distributed sufficiently far in advance so that the former partners can establish that they
“held” the real property individually prior to the second step of the transaction.
Case law on these multi-step transactions tends to be favorable to
taxpayers, but the very existence of a body of case law shows that the IRS has been ready and
willing to litigate this issue at various times in the past. See Maloney v. Com’r, 93 TC 89 (1989)
(investment property held by corporation was exchanged for other investment property and then
the corporation distributed the replacement property in a Code §333 liquidation; held, the first
transaction was a Code §1031 exchange notwithstanding subsequent liquidation); see also
Magneson v. Com’r, 81 TC 767 (1983), aff’d, 753 F.2d 1490 (9th Cir. 1985) (investment
property exchanged for 10% individual interest in second property that, under pre-arranged plan,
was then contributed to a partnership for a 9-10% general partnership interest; second property
satisfied “held” requirement; court suggested different result might apply if second property was
immediately contributed for limited partnership interest or stock in a corporation instead of
general partnership interest.)
“Like Kind” Property Defined – Real Estate.
The words “like kind” have reference to the “nature or character of the
property, and not its grade or quality.” Reg. §1.1031(a)-1(b).
All real estate is like kind to all other real estate. Reg. §1.1031(a)-1(b).
Thus, improved real estate used in a trade or business can be exchanged under Code §1031 for
unimproved land to be held for investment.
The simple statement in the regulations that “all real estate is like kind to
all other real estate” opens up enormous creative opportunities for like-kind exchanges of
property that qualifies as “real estate” under applicable state law.
A lease of real property with a remaining term of 30 years is considered
“like kind” to a fee interest in real estate. Reg. §1.1031(a)-1(c). Shorter leaseholds are like kind
to equivalent leaseholds. Rev. Rul. 76-301.
An undivided interest as tenants in common in a parcel of real property
can be exchanged for sole ownership of another parcel of real property. Rev. Rul. 79-44; Rev.
Rul. 73-476.
For example: Three individuals each owned an undivided interest as a
tenant in common in three separate parcels of real property held for investment.
Each exchanged his undivided interest in the three separate parcels for a 100%
ownership of one parcel. No boot was paid by any of them. Each taxpayer
continued to hold as an investment the single parcel he had received. No gain or
loss is recognized. Rev. Rul. 73-476.
Water rights are classified as a “real property” right in many states,
especially western states, and can be exchanged for a fee simple interest in other real property.
Rev. Rul. 55 – 749; PLR 200404044.
Timber rights – the right to harvest timber on a particular parcel of real
estate – is often classified as a real estate interest, and the IRS has ruled that timber rights can be
exchanged for a fee simple interest in other real property. TAM 9525002.
A perpetual easement is another interest in real estate that is typically
classified as real property, and the IRS has ruled that a perpetual easement can be exchanged for
a fee simple interest in real estate. PLR 9601046. Other, more specific IRS rulings have
concluded that an agricultural easement in farm property can be exchanged for a fee simple
interest in other farm property, PLR 9621012, that a perpetual scenic conservation easement on
ranch land can be exchanged for timberland, farmland, and ranch land, PLR 9621012, and that
an agricultural easement can be exchanged a fee simple interest in real estate, PLR 9232030.
Foreign real property and US real property are not “like kind” for purposes
of §1031. Code § 1031(h)(2).
“Like Kind” Property Defined – Tangible Personal Property
It it clear that taxpayers can do a like-kind exchange of tangible personal
property held for qualifying purposes (i.e., held for business use or investment) for other tangible
personal property to be held for qualifying purposes. For example, an exchange of a truck used
in a trade or business for a new truck to be used in a trade or business, or an automobile used in a
trade or business for a new automobile to be used in the trade or business, constitutes a like-kind
exchange. Reg. § 1.1031(a)-1(c).
However, certain kinds of personal property are expressly excluded by
statute from being eligible to be exchanged under Code §1031. These include stock in trade or
other property held primarily for sale; stocks, bonds or notes; other securities or evidences of
indebtedness or interest; interests in a partnership; certificates of trust or beneficial interest; or
chooses in action. See Code §1031(a)(2).
The biggest constraint on implementing an exchange of non-real estate
business assets is usually the requirement that the exchanged assets be of "like kind."
As noted above, the term "like kind" refers to the "nature or character of
the property, and not its grade or quality.” Reg. §1.1031(a)-1(b). One kind or class of property
may not be exchanged for property of a different kind or class.
Like-kind exchanges have encompassed everything from exchanges of
major league baseball contracts, Rev. Rul. 67-380, 1967-2 CB 291, to exchanges of 49 steer
calves aged 7 to 11 months for registered Aberdeen-Angus cattle. C.H. Wylie, D.C. Tex., 68-1
USTC ¶ 9287, 281 F. Supp. 180.
The IRS has ruled that sports utility vehicles and passenger automobiles
are like-kind property, based on the conclusion that the differences between an automobile and
an SUV do not rise to the level of a difference in nature or character but are merely differences in
grade or quality. PLR 200450005, August 30, 2004. However, the IRS reached an opposite
conclusion in ruling that a light duty truck is not of like-kind to an automobile because the
vehicle is different in nature and character. PLR 200240049, July 1, 2002.
Reg. § 1.1031(a)-2 provides a variety of rules for determining whether an
exchange of personal property is considered to be either of "like kind" or of "like class." The
regulation states that personal properties of a "like class" are considered to be of a "like kind" for
Code Sec. 1031 purposes. Reg. § 1.1031-2(a). In addition, an exchange of like-kind property
qualifies for nonrecognition whether or not such properties are of ‘like class.” Id. In determining
whether exchanged properties are of like kind, no inference is to be drawn from the fact that the
properties are not of a like class." Id.
This far-from-intuitive discussion about "like kind" and "like class" is
further explained and applied to depreciable tangible personal property by a classification system
implemented in the regulations. The regulations provide for and define 13 General Asset
Classes," which are based in the asset classes originally defined in Rev. Proc. 87-56, and also
define Product Classes, which are based on the six-digit product classes defined under the North
American Industry Classification System (NAICS).
Depreciable tangible personal property is of like class to other depreciable
tangible personal property (and therefore "like kind") if they are either within the same General
Asset Class or within the same Product Class. Reg. §1.1031(a)-2(b)(1). A single property may
not be classified within more than one General Asset Class or within more than one Product
Class. In addition, property classified within any General Asset Class may not be classified
within a Product Class. A property's General Asset Class or Product Class is determined as of the
date of the exchange.
Reg. § 1031(a)-2(b) (2) provides for 13 General Asset Classes, based on
the classes set forth in Rev. Proc. 87-56. These include the following: Office furniture, fixtures,
and equipment (asset class 00.11); infornation systems (computers and peripheral equipment)
(asset class 00.12); data handling equipment, except computers (asset class 00.13); airplanes
(airframes and engines), except those used in commercial or contract carrying of passengers or
freight, and all helicopters (airframes and engines) (asset class 00.21); automobiles and taxis
(asset class 00.22); buses (asset class 00.23); light general purpose trucks (asset class 00.241);
heavy general purpose trucks (asset class 00.242); railroad cars and locomotives, except those
owned by railroad transportation companies (asset class 00.25); tractor units for use over-theroad (asset class 00.26); trailers and trailer-mounted containers (asset class 00.27); vessels,
barges, tugs, and similar water-transportation equipment, except those used in marine
construction (asset class 00.28); and industrial steam and electric generation and/or distribution
systems (asset class 00.4).
The regulations also define Product Classes, which consist of tangible
personal property that is described in a six-digit product class within Sections 31, 32, and 33 of
the North American Industry Classification System (NAICS) set forth in the Office of
Management and Budgets' North American Industry Classification Systern (2002), as
periodically updated ("the NAICS Manual"). Any six-digit Product Class ending in the number
"9" (a miscellaneous category) is not considered a Product Class, and therefore property in such
category cannot be considered of "like class" based on the NAICS Manual. However, the
property may still be shown to be of like kind to other property. Property that is listed in more
than one Product Class is treated as listed in any one of those Product Classes.
Reg. § 1.1031(a)-2(b)(7) provides the following examples to illustrate
these rules:
Example I. Taxpayer A transfers a personal computer (asset class
00.12) to B in exchange for a printer (asset class 00.12). With respect to A, the properties
exchanged are within the same General Asset Class and therefore are of a like class.
Example 2. Taxpayer C transfers an airplane (asset class 00.21) to
D in exchange for a heavy general purpose truck (asset class 00.242). The properties exchanged
are not of a like class because they are within different General Asset Classes. Because each of
the properties is within a General Asset Class, the properties may not be classified within a
Product Class. The airplane and heavy general purpose truck are also not of a like kind.
Therefore, the exchange does not qualify for nonrecognition of gain or loss under section 1031.
Example 3. Taxpayer E transfers a grader to F in exchange for a
scraper. Neither property is within any of the general asset classes. However, both properties are
within the same product class (NAICS code 333120). The grader and scraper are of a like class
and deemed to be of a like kind for purposes of section 1031.
Example 4. Taxpayer G transfers a personal computer (asset class
00.12), an airplane (asset class 00.21) and a sanding machine (NAICS code 333210), to H in
exchange for a printer (asset class 00.12), a heavy general purpose truck (asset class 00.242) and
a lathe (NAICS code 333210). The personal computer and the printer are of a like class because
they are within the same general asset class. The sanding machine and the lathe are of a like class
because they are within the same product class (although neither property is within any of th
general asset classes). The airplane and the heavy general purpose truck are neither within the
same general asset class nor within the same product class, and are not of a like kind.
Like Kind Proeprty Defined – Intangible Personal Property
Intangible personal property and nondepreciable personal property can
also be eligible for Code Sec. 1031 exchange treatment. Reg. § 1.1031(a)-2(c)(1). However, a
determination of what is and is not of "like kind" is often even more uncertain and complex than
with tangible property. Under the regulations, intangible personal property is not divided into
"classes," both because of the variety of such kinds of property and the lack of a readily available
classification system. Instead, the regulations state that the like-kind test "depends on the nature
or character of the rights involved (e.g., a patent or a copyright) and also on the nature or
character of the underlying property to which the intangible personal property relates."
The regulations take the very broad and encompassing view that goodwill
and going concern value of a business are never like kind to the goodwill and going concern
value of another business. Reg. § 1.1031(a)-2(c)(2). Note: It is not clear that this regulatory
prohibition on exchanging goodwill and going concern is within the regulatory authority of the
IRS. The ambiguity is especially pronounced since many of the assets that the IRS does
recognize as exchangeable, namely trademarks, trade names, and other similar assets, often have
substantial goodwill or going concern value.
The following examples from the regulations, Reg. § 1.1031(a)-2(c)(3),
illustrate these rules:
Example (1). Taxpayer K exchanges a copyright on a novel for a
copyright on a different novel. The properties exchanged are of a like kind.
Example (2). Taxpayer J exchanges a copyright on a novel for a
copyright on a song. The properties exchanged are not of a like kind.
“Exchange” Requirement.
The "exchange" requirement is simultaneously a necessary and an
exceedingly awkward element of Code Sec. 1031. The exchange requirement has always been
part of the statutory scheme laid out in Code Sec. 1031 and its predecessor provisions, and today
it continues to be a required element in order to enjoy nonrecognition benefits. However, one can
argue rather compellingly that the so-called Starker Regulations enacted in 1991 (discussed more
fully below) and subsequent IRS rulings and procedures have transformed the "exchange"
requirement into a mere formality that is all form and no substance, and that today the
requirement is simply a vestige from the past.
Nonetheless, the "exchange" element remains a basic requirement and
often a major hurdle in structuring a transaction to qualify for the nonrecognition benefits of
Code Sec. 1031.
The exchange requirement is conceptually straightforward if only two
parties are involved. However, in the real world it is difficult to locate and match up two parties
willing to enter into a true bi-lateral exchange transaction, and so exchanges were notably
difficult to implement prior to 1991. In that year, the IRS issued under Section 1031 the "Starker
Regulations" which gave a formal blessing to the use of a "qualified intermediary," who is a
party paid a fee by the taxpayer to facilitate an exchange.
Under the Starker Regulatinos, a taxpayer can engage a qualified
intermediary, find a purchaser ("buyer") of the taxpayer's current property (the "relinquished
property"), sell the relinquished property through the qualified intermediary to the buyer, and use
the proceeds from that sale to purchase like-kind property (the "replacement property") through
the qualified intermediary from a separate, unrelated party ("seller").
These regulations also approved (and gave substantial guidance on how to
implement) a so-called “deferred exchange,” whereby the qualified intermediary sells the
relinquished property to the buyer, and then holds the proceeds for a period of up to 180 days
while the taxpayer identifies (within 45 days) and then enters into a purchase contract for the
replacement property, which property is then acquired by the qualified intermediary and
transferred to the taxpayer, all within the applicable 180-day period.
Deferred like-kind exchanges will be discussed in Article V below.
In Rev. Proc. 2000-37, the IRS provided rules and procedures that allowed
a taxpayer to acquire the replacement property before selling the relinquished property, a
transaction generally described as a “reverse exchange.”
There is a related-party rule, such that if the taxpayer directly or indirectly
exchanges property with a related party in a §1031 exchange, and within two years either the
related party or the taxpayer disposes of the property, the original exchange will not qualify for
non-recognition under §1031. There are exceptions to this related party rule, including
dispositions due to death, involuntary conversion, and those made for non-tax avoidance
Meaning of “Boot.” Code §1031 allows the taxpayer to avoid recognition
of gain only if the like-kind property is exchanged “solely” for property of a like kind. It is
virtually impossible in the real world to find a parcel of real estate exactly equal in value to the
parcel that you are transferring. Accordingly, there is almost always an adjustment between the
parties in the form of cash and/or assumption of debt. In general, the receipt of any nonqualifying property, including but not limited to cash, and including specifically the income
imputed to a taxpayer as a result of the net assumption of indebtedness by the other party in
exchange, is called “boot” and results in taxable income or gain being recognized by the
transferor in the exchange transaction, up to the lesser of the total gain or the full amount of the
boot. It should be emphasized, however, that even when “boot” is received, the remaining
portion of the gain in excess of the boot amount will be eligible for Code §1031 treatment.
Amount of Boot. Boot rules are mechanical to apply but complex. As
noted above, boot causes recognition of gain in an amount equal to the lesser of (a) the full
amount of gain realized in the exchange, or (b) the amount of the boot.
Types of Boot. Boot is the non-qualifying property received in addition to
qualifying property in a §1031 exchange. The amount of boot is equal to the sum of the money
plus the fair market value of the other non-qualifying property received in the exchange. The
amount of a taxpayer’s liabilities assumed by the other party in the exchange or the amount of
any liabilities attaching to the property transferred by the taxpayer is treated as money received
by the taxpayer in the exchange. Reg. §1.1031(b)-1(c). Consideration given in the form of cash
or other property is netted against consideration received in the form of an assumption of liability
or a transfer of property subject to a liability. Consideration received in the form of cash or other
property is not, however, netted against consideration given in the form of an assumption of
liability or a receipt of properties subject to a liability.
Examples of Boot Rules.
Example 1: Taxpayer A, in a transaction qualifying under §1031,
transfers property with a fair-market value of $200 and subject to a liability of $100 to B in
exchange for property with a fair-market value of $150 and subject to a liability of $50. Since
the transaction resulted in a reduction of $50 in the amount of liabilities to which the A’s
property was subject, he is deemed to have received boot to that extent. Therefore up to $50 of
the gain realized by A is taxable. However, B received no boot in the exchange since he
experienced a net increase in indebtedness.
Example 2: Taxpayer C, in a transaction qualifying under §1031,
transfers property with a fair-market value of $300 and subject to a liability of $200 plus cash of
$50 and securities worth $50 to D in exchange for property with a fair-market value of $250 and
subject to a liability of $50. C has received boot in the amount of $50: indebtedness relieved
($200), less indebtedness acquired ($50) and less cash and securities given ($100). D has
received boot in the amount of $100: the value of the cash and securities received.
Example 3: Taxpayer E, in a transaction qualifying under §1031,
transfers property with a fair-market value of $350 and subject to a liability of $150 to F in
exchange for property with a fair-market value of $300 and subject to a liability of $200 plus
cash in the amount of $100. E has received boot in the amount of $100: indebtedness relieved
($150) is offset by indebtedness acquired ($200), but E must recognize $100 of boot for the cash
received. This illustrates that although a taxpayer may net boot given in the form of
indebtedness against boot received in the form of indebtedness, he may not net boot given in the
form of indebtedness against other forms of boot received.
Capital Gain Treatment. Where boot is received by a party in a
transaction otherwise qualifying under Code §1031, the taxpayer typically recognizes capital
gain. This is because, by definition, an asset qualifying under Code §1031 must necessarily be a
capital asset (or a Code §1231 asset) in the hands of the exchangor. However, it is possible to
realize a recapture of depreciation under Code §1245 and §1250 in a §1031 exchange, in which
case the recognition of boot can result in recognition of ordinary income. Also, an investment
tax credit must be recaptured on a disposition of the investment property and this recapture rule
encompasses dispositions pursuant to tax-free exchanges.
Alternative Minimum Tax. As a general rule, there are tax reasons that
make it preferable not to hold real property in a “C” corporation. However, there are many “C”
corporations that hold real property for a variety of special reasons. Be aware that if a “C”
corporation engages in a Code §1031 transaction, the exchange may be tax free for regular tax
purposes, but can still generate alternative-minimum-tax liability, because a like-kind exchange
is a recognition event for purposes of “earnings and profits” preference under Code §56(g).
Basis and Depreciation.
Basis. The basis of property received in an exchange qualifying under
§1031 is the basis of the property surrendered, decreased by the amount of money received, and
then increased by any gain or decreased by any loss recognized on the exchange. Code
§1031(d). The basis of the property received is also increased by the amount of brokerage
commissions paid by the taxpayer. Rev. Rul. 72-456.
Depreciation. The IRS takes the position that property received in a
§1031 exchange is depreciated under the MACRS convention of current Code §168, even if the
relinquished property was depreciated under the more favorable ACRS convention. PLR
Pre-1991 Transactions.
Before the issuance of the Starker Regulations in 1991, it was relatively
difficult to implement a like-kind exchange. The “exchange” requirement was viewed as a rigid
and limiting impediment, and it was necessary to structure a transaction such that the taxpayer
was transferring the relinquished property to a party in exchange for a replacement property.
During that period, it was not uncommon for Taxpayer X to ask Y, the
pending buyer of the relinquished property, to act as the counter-party in an “exchange,” and to
have Y acquire the replacement property selected by X and then transfer the replacement
property to X in exchange for the relinquished property. Needless to say, these transactions were
difficult to implement, especially where Y was not a real estate professional involved in the real
estate business and had little understanding and even less appetite for engaging in complex,
multi-party transactions.
Although “deferred” exchanges were permitted by the Starker case
(decided in 1979) and by the Starker Regulations (enacted in 1984), most prudent taxpayers prior
to were reluctant to structure a deferred exchange directly with a single priate counter-party,
because of the practical economic risk that the counter-party might not be able to perform the
replacement transaction obligations at the applicable future time.
Realistically, a taxpayer transferring a relinquished property to a buyer
wanted the proceeds held in escrow pending the purchase of the replacement property. However,
prior to 1991, there were significant concerns that funds held in escrow would constitute
contructive receipt and thus would vitiate the exchange.
Regulations — Qualified Intermediary.
The §1031 Regulations, Reg. §1.1031(k)-1(g)(4), provide for a “qualified
intermediary” or “QI” who can serve as a facilitator in a like-kind exchange transaction without
causing the original transferor to be deemed to have actual or constructive receipt of money.
Thus, Taxapyer X can assign the relinquished property to the QI who in turn can transfer it to Y
in exchange for money, and the QI can then purchase a replacement property from Z and assign
and transfer such to X to complete the “exchange.”
A qualified intermediary is a person who (a) is not the taxpayer or a
“disqualified person,” and (b) acts to facilitate the deferred exchange by entering into a written
agreement with the taxpayer for the exchange of properties pursuant to which such person
acquires the relinquished property from the taxpayer (either on its own behalf or as the agent of
any party to the transaction), transfers the relinquished property, acquires the replacement
property (either on its own behalf or as the agent of any party to the transaction), and transfers
the replacement property to the taxpayer. Reg. §1.1031(k)-1(g)(4).
The relationship test for purposes of this rule is set forth in Reg.
§1.1031(k)-1(k) (“Paragraph (k)”). Paragraph (k) states that a person is a related party if the
person is described in paragraphs (k)(2), (k)(3), or (k)(4), which read as follows:
The person is the agent of the taxpayer at the time of the transaction. For this
purpose, a person who has acted as the taxpayer’s employee, attorney, accountant,
investment banker or broker, or real estate agent or broker within the 2-year period ending
on the date of the transfer of the first of the relinquished properties is treated as an agent of
the taxpayer at the time of the transaction. Solely for purposes of this paragraph (b)(2),
performance of the following services will not be taken into account—
services for the taxpayer with respect to exchanges of property
intended to qualify for nonrecognition of gain or loss under section 1031;
Routine financial, title insurance, escrow, or trust services for the
taxpayer by a financial institution, title insurance company or escrow
The person and the taxpayer bear a relationship described in either section 267(b)
or section 707(b) (determined by substituting “10 percent” for “50 percent” each place it
The person and a person described in paragraph (k)(2) of this section bear a
relationship described in either section 267(b) or section 707(b) (determined by
substituting “10 percent” for “50 percent” each place it appears).
The special exemption for a qualified intermediary in Reg. §1.1031(k)1(g)(4) applies only if the taxpayer’s right to receive money or other property from the qualified
intermediary is limited to circumstances defined in Reg. §1.1031(k)-1(g)(6) (“Paragraph (g)(6)”)
that correspond with the Statutory Starker rules, described more fully below.
Statutory Starker Rules.
In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the court
approved a five-year deferral in completion of a §1031 transaction, which led to statutory
changes enacted in 1984 that are embodied in Code §1031(a)(3).
The “Statutory Starker” rules require that the parties to the exchange must
identify the replacement property within 45 days of a transfer, and close the exchange within 180
days of the first transfer or the filing date of the transferor’s return, whichever is earlier.
A “reverse Starker” exchange, in which the taxpayer receives replacement
property before he transfers the relinquished property, is still not expressly blessed by the Code
and was not initially permitted under the 1991 Starker Regulations, discussed below. However,
a “reverse exchange” was formally authorized and approved by the IRS in Rev. Proc. 2000-37.
1991 Starker Regulations.
Although the Statutory Starker rules were made part of the Code in1984,
there was initially a great deal of uncertainty about how to apply and implement these rules in a
deferred like-kind exchange transaction. One vexing problem was the fact that the transferor of
the relinquished property wanted security that the money being “paid” by the transferee was
going to be used to acquire the replacement property, and in particular was not going to be spent,
lost, seized by creditors, etc. However, use of an escrow caused concern that the cash might be
viewed as being constructively received by the transferor, resulting in a taxable sale rather than a
tax-free exchange. These concerns led parties to use a variety of complicated escrow
arrangements, but such arrangements never provided the degree of certainty or confidence that
lawyers and taxpayers like to have in organizing their affairs.
The 1991 Regulations provided for the first time a great deal of certainty
about how to structure many important aspects of these transactions. However, the Regulations
naturally produced a series of new issues and questions, which continue to emerge as attorneys
implement the regulations in actual transactions.
Identification and Receipt Requirements.
The Regulations specify the manner for identifying replacement property.
It must be identified in a written document signed by the taxpayer and hand-delivered, mailed,
telecopied, or otherwise sent before the end of the identification period (45 days from the date of
the original transfer) to a person involved in the exchange other than the taxpayer or a
disqualified person (as defined in Paragraph (k)). Reg. §1.1031(k)-1(c)(2). An identification
made in a written agreement signed by all parties thereto before the end of the identification
period will be treated as meeting the identification requirements whether the agreement is “sent”
to a person involved in the exchange. Reg. §1.1031(k)-1(c)(2).
Notwithstanding the rule described in the preceding paragraph, if
replacement property is received by the taxpayer before the end of the ID Period, the property
will be treated as identified before the end of such period. Reg. §1.1031(k)-1(c)(1).
Replacement property is identified only if it is unambiguously described in
the written document or agreement. Real property generally is unambiguously described if it is
described by a legal description or street address or distinguishable name (such as “Empire State
Building”). Reg. §1.1031(k)-1(c)(3).
The Regulations provide important flexibility by allowing taxpayers to
identify more than one property as replacement property. Regardless of the number of
relinquished properties transferred by the taxpayer as part of the exchange, the maximum number
of replacement properties the taxpayer may identify is (a) three properties without regard to the
fair-market value of the properties (the “Three-Property Rule”), or (b) any number of properties
as long as their aggregate fair-market value (on a gross basis — i.e., without regard to liabilities
which encumber the property) as of the end of the identification period does not exceed 200% of
the aggregate fair-market value of all the relinquished properties as of the date the relinquished
properties were transferred by the taxpayer (the “200% Rule”). Prop. Reg. §1.1031(k)-1(c)(4).
If, as of the end of the identification period, the taxpayer has identified
more properties than permitted by the Three-Property Rule or the 200% Rule, the taxpayer is
treated as if no replacement property had been identified. Reg. §1.1031(k)-1(c)(4)(ii). However,
the identification requirements will be deemed satisfied with respect to (a) any property received
by the taxpayer before the end of the ID Period, and (b) any replacement property identified
before the end of the ID Period and received before the end of the exchange period, but only if
the taxpayer receives before the end of the exchange period identified replacement property
constituting at least 95% of the aggregate fair-market value of all identified replacement
properties. Reg. §1.1031(k)-1(c)(4)(ii).
An identification of property may be revoked at any time before the end of
the identification period if the revocation is made in a written document signed by the taxpayer
and delivered, in the same manner as required for the original identification notice, to the person
to whom the original identification notice was sent. Reg. §1.1031(k)-1(c)(6).
Receipt of “Identified Replacement Property”.
Once property is identified, the taxpayer will be deemed to have received
the identified property if he (a) receives it before the end of the exchange period, and (b) it is
“substantially the same property” as identified. Reg. §1.1031(k)-1(d). The regulations do not
define “substantially,” but Example 4 in the regulations indicates an informal “75%” test. Thus,
if B identifies real property P, consisting of two acres of unimproved land with the fair-market
value of $250,000, and later receives one and one-half acres of property P for an assumed
transactional value of $187,500, and the portion received does not differ from the basic nature or
character of P as a whole, B is considered to have received substantially the same property as
identified. (Note: This is a simplification of a much more complicated fact pattern.)
Special Rules for Identification and Receipt of Property To Be Produced.
The regulations confirm that it is possible to have a Code §1031
transaction where the replacement property is not yet in existence at the time it is “identified” as
replacement property. Reg. §1.1031(k)-1(e).
“Identification” of property to be produced requires a legal description of
the underlying land, and as much detail as practicable at the time of identification about the
construction of the anticipated improvements. In turn, whether there is receipt of the “identified
replacement property” is determined by whether the taxpayer has received substantially the same
“property” described at the time of the identification, allowing for variations due to usual or
typical production changes. However, if substantial changes are made in the property to be
produced, the replacement property received will not be considered to be substantially the same
property as identified.
The 180-day rule continues to apply to this type of transaction, so the
property must be received within the 180-day period whether or not it is completed. Any
additional production occurring with respect to the replacement property after the property is
received by the taxpayer will not be treated as receipt of property of a like kind.
Receipt of Money or other Property.
Reg. §1.1031(k)-1(f) and -1(g) provide general rules about actual or constructive receipt. The
regulations basically indicate that if a taxpayer does not comply with the safe harbors, described
more fully below, the constructive-receipt doctrine remains a substantial problem.
Safe Harbors.
Safe Harbors. Perhaps the most valuable clarification provided by the
Regulations is the ways in which one can provide security for the money to be used to acquire
the replacement property, while the acquisition of the replacement property is being arranged.
The regulations, Reg. §1.1031(k)-1(g), provide four safe harbors to use in deferred exchanges
that will result in a determination that the taxpayer is not in actual or constructive receipt of
money or other property for purposes of Code §1031.
Security or Guaranty Arrangements. The regulations provide that
constructive receipt will be determined without regard to the fact that the obligation of the
transferee to transfer replacement property may be secured or guaranteed by (a) a mortgage, a
deed of trust, or other security interest in property (other than cash or a cash equivalent), (b) a
standby letter of credit which satisfies all the requirements of Temp. Reg. §15A.453-1(b)(3)(iii)
and which does not allow the taxpayer to draw on the standby letter of credit except upon a
default of the transferee’s obligation to transfer replacement property, or (c) a guaranty of a third
party. Reg. §1.1031(k)-1(g)(2).
Qualified Escrow Accounts and Qualified Trusts. This permits the parties
to put cash or cash equivalent into a qualified escrow account or qualified trust to be held until
the replacement property is acquired. A qualified escrow is an escrow where (a) the escrow
holder is not the taxpayer or a disqualified person (as defined in Paragraph (k)), and (b) the
taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash
equivalent held in escrow are expressly limited by the agreement to the Paragraph (g)(6)
restrictions. Reg. §1.1031(k)-1(g)(3)(ii). A qualified trust is a trust where (a) the trustee is not
the taxpayer or a disqualified person (as defined in Paragraph (k)) and (b) the taxpayer’s right to
receive, pledge, borrow or otherwise obtain the cash equivalent from the trustee is expressly
limited by the agreement to circumstances set forth in Paragraph (g)(6). Reg. §1.1031(k)1(g)(3)(iii). Additionally, Reg. §1.1031(k)-1(g)(3)(iv) states that rights conferred upon a
taxpayer under state law to terminate or dismiss the escrow agent of a qualified escrow account
or the trustee of a qualified trust or a qualified intermediary will not jeopardize the use of the safe
harbor. Similarly, the application of the safe harbor is not affected by a taxpayer’s rights to
receive money or other boot directly from a party other than the escrow agent, trustee or
qualified intermediary. Reg. §1.1031(k)-1(g)(3)(v).
Qualified Intermediaries. This exception is described above. Note that
this is the only safe harbor for simultaneous as opposed to deferred exchanges.
Interest and Growth Factors. The transferor can receive interest or growth
factors with respect to the funds in an escrow account without being deemed to have actual or
constructive receipt of the funds. However, the right to receive the interest or growth factor, as
with the cash, must be limited by an agreement to the Paragraph (g)(6) circumstances. Reg.
Paragraph (g)(6). Reg. §1.1031(k)-1(g)(6) describe required limits on a
taxpayer’s right to receive proceeds during an exchange transaction. These rules state that the
taxpayer cannot receive, pledge, borrow or otherwise obtain the benefits of money or other
property until (a) the end of the ID Period, if the taxpayer has not identified replacement property
before the end of the ID Period; (b) after the taxpayer has received all of the identified
replacement property to which the taxpayer is entitled; (c) the occurrence after the end of the ID
Period of a material and substantial contingency that (i) relates to the deferred exchange, (ii) is
provided for in writing, and (c) is beyond the control of the taxpayer and any disqualified person;
or (d) otherwise, after the end of the exchange period. These provisions are specifically geared
to the Statutory Starker rules and deferred like-kind exchanges.
Items Disregarded in Applying Safe Harbors. Reg. §1.1031(k)-1(g)(7)
provides that in determining whether a safe harbor applies, the taxpayer’s receipt of or right to
receive the following items will be disregarded: (a) items received as a consequence of
disposition which are not included in amounts realized, such as pro-rated rents and (b) traditional
transactional items such as commissions and closing costs.
JBD3 Comments.
Qualified Intermediaries. A number of companies have sprung up
offering to provide services as qualified intermediaries for Code §1031 transactions. Some
charge a flat fee (e.g., $5,000), while others charge a rate that is based on the value of the
property being exchanged (e.g., 1% of the value of the transaction).
Identification. This is a very simple procedure, but unsupervised clients
will make mistakes. Advisers should caution their clients to follow strictly the procedures set
forth in the regulations.
Security an Issue. Before the issuance of the regulations, an escrow
arrangement that did not result in constructive receipt to the transferor of the escrowed funds
almost by definition meant that the escrowed funds remained assets of the transferee.
Unfortunately, one consequence of this legal conclusion was that the funds were reachable by the
creditors of the transferee in the event of insolvency, bankruptcy, etc. Transferors were usually
most concerned about the transferee dipping into the money, and so escrows were placed with
reliable parties, rabbi trusts were sometimes used (this did not solve the exposure to creditors of
the transferee, but at least it precluded the transferee from reaching the money under any
circumstances), and sometimes the transferor would even sign the escrow agreement as a “thirdparty beneficiary.” The complexity of these escrow arrangements reflected the fact that two
fundamentally inconsistent objectives were trying to be established simultaneously: (1) that the
transferor did not receive the money, and (2) the transferee had no right to the money.
Regulations Approve Certain Security Arrangements. The Regulations
provide for security arrangements including mortgages and letters of credit. However, these
remain imperfect answers to the fundamental quest for perfect security for the transferor. For
example, the transferor can take a security interest in the transferred property to secure
performance of the like-kind exchange, but if the transferee has obtained bank financing there
may be little or no equity in the property. A letter of credit secured by the transferee in favor of
the transferor, and probably secured by a bank deposit containing the escrowed proceeds, may
provide an answer, although the transferor will presumably absorb the cost of the letter of credit
as part of the transaction costs. This is in effect an insurance payment to minimize risk in the
Breaking the Escrow Early. In the absence of an ideal security
arrangement, funds in escrow remain reachable by creditors of the transferee. If the transferor
enters into a deferred like-kind exchange transaction, and it becomes impossible to close within
180 days on any of the properties identified within the identification period for reasons not
previously contemplated and written into the agreement, it probably makes sense for the
transferor to ask the other parties to break the escrow, so that he can get the funds as soon as
possible. If properly drafted, the escrow agreement will not give the transferor a unilateral right
to demand the money because of the Paragraph (g)(6) restrictions. However, as a practical
manner, the transferee and the escrow agent will most likely not object to an early termination of
the escrow. The consequence of terminating the escrow early is that the transaction is taxable,
but if the transferor has previously determined that there is no likelihood of completing a taxdeferred transaction then there is no actual harm to anyone.
Timing of Gain. The Regulations do not adequately address the timing of
recognition of gain. For example, if a taxpayer entered into an exchange arrangement and
transferred property on December 10, 1992, but the exchange fell through in January 1993 and
the taxpayer received cash in 1993, in what year should the gain be recognized? The
Regulations do not provide an answer.
A "Reverse Starker" exchange, in which the taxpayer receives replacement
property before he or she transfers the relinquished property, is now also permitted under a "safe
harbor" promulgated by the IRS in Rev. Proc. 2000-37."
Also called a "parking transaction," the taxpayer can acquire the intended
replacement property in advance and can "park" the property with an "exchange accommodation
titleholder" (EAT) until the taxpayer is ready to implement a conventional "forward exchange"
using a qualified intermediary (QI).
The taxpayer typically advances the funds to the EAT through a loan, and
the EAT acquires the replacement property, which is then typically “leased” to the taxpayer for a
nominal amount, e.g. $1, under a triple-net lease that transfers both the economic burdens and
economic benefits to the taxpayer. However, legal title in the replacement property is held by
the EAT, and, among other things, neither the EAT nor the taxpayer claims depreciation
deductions on the lease property, until the exchange is completed.
The QI, which is permitted to be the EAT but which, in practice, is almost
always a separate entity related to the EAT, is subsequently assigned the purchase and sale
agreement for the relinquished property, transfers that relinquished property to the buyer, uses
the cash proceeds from the sale to pay some or all of the loan advanced by the taxpayer to
purchase the parked property (which is now the replacement property in the exchange) and then
transfers the parked property in completion of its exchange obligations to the taxpayer.
Rev. Proc. 2000-37 generally looks to the regulations governing deferred
exchanges to provide similar rules for parking transactions (e.g., with respect to identification
and other mechanical rules and procedures).
Rev. Proc. 2000-37
Rev. Proc. 2000-37, 2000-2 C.B. 308, October 2, 2000, provides a safe
harbor under which the Internal Revenue Service will not challenge (a) the qualification of
property as either "replacement property" or "relinquished property" (as defined in § 1.1031(k)1(a) of the Income Tax Regulations) for purposes of § 1031 of the Internal Revenue Code and
the regulations thereunder or (b) the treatment of the "exchange accommodation titleholder" as
the beneficial owner of such property for federal income tax purposes, if the property is held in a
"qualified exchange accommodation arrangement" (QEAA), as defined in this revenue
The preamble to the 1991 Starter Regulations stated that the deferred
exchange rules under § 1031(a)(3) do not apply to reverse-Starker exchanges (i.e., exchanges
where the replacement property is acquired before the relinquished property is
transferred) and consequently that the final regulations did not apply to such
exchanges. However, the preamble indicated that Treasury and the Service
will continue to study the applicability of the general rule of § 1031(a)(1) to these
Rev. Proc. 2000-37 states: “Treasury and the Service have determined that
it is in the best interest of sound tax administration to provide taxpayers with a workable means
of qualifying their transactions under § 1031 in situations where the taxpayer has a genuine
intent to accomplish a like-kind exchange at the time that it arranges for the acquisition of the
replacement property and actually accomplishes the exchange within a short time
thereafter. Accordingly, this revenue procedure provides a safe harbor that allows a
taxpayer to treat the accommodation party as the owner of the property for federal
income tax purposes, thereby enabling the taxpayer to accomplish a qualifying likekind
The safe harbor provided under Rev. Proc. 2000-37 is for a transaction
structured as a “Qualified Exchange Accommodation Arrangement” or QEAA. A QEAA exists
if all of the following requirements are met:
(1) Qualified indicia of ownership of the property is held by a
person (the "exchange accommodation titleholder") who is not the taxpayer or a disqualified
person and either such person is subject to federal income tax or, if such person is treated as a
partnership or S corporation for federal income tax purposes, more than 90 percent of its interests
or stock are owned by partners or shareholders who are subject to federal income tax. Such
qualified indicia of ownership must be held by the exchange accommodation titleholder at all
times from the date of acquisition by the exchange accommodation titleholder until the property
is transferred as described in section 4.02(5) of this revenue procedure. For this purpose,
"qualified indicia of ownership" means legal title to the property, other indicia of ownership of
the property that are treated as beneficial ownership of the property under applicable principles
of commercial law (e.g., a contract for deed), or interests in an entity that is disregarded as an
entity separate from its owner for federal income tax purposes (e.g., a single member limited
liability company) and that holds either legal title to the property or such other indicia of
(2) At the time the qualified indicia of ownership of the property is
transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that
the property held by the exchange accommodation titleholder represent either replacement
property or relinquished property in an exchange that is intended to qualify for nonrecognition of
gain (in whole or in part) or loss under § 1031;
(3) No later than five business days after the transfer of qualified
indicia of ownership of the property to the exchange accommodation titleholder, the taxpayer
and the exchange accommodation titleholder enter into a written agreement (the "qualified
exchange accommodation agreement") that provides that the exchange accommodation
titleholder is holding the property for the benefit of the taxpayer in order to facilitate an exchange
under § 1031 and this revenue procedure and that the taxpayer and the exchange accommodation
titleholder agree to report the acquisition, holding, and disposition of the property as provided in
this revenue procedure. The agreement must specify that the exchange accommodation
titleholder will be treated as the beneficial owner of the property for all federal income tax
purposes. Both parties must report the federal income tax attributes of the property on their
federal income tax returns in a manner consistent with this agreement;
(4) No later than 45 days after the transfer of qualified indicia of
ownership of the replacement property to the exchange accommodation titleholder, the
relinquished property is properly identified. Identification must be made in a manner consistent
with the principles described in § 1.1031(k)-1(c). For purposes of this section, the taxpayer may
properly identify alternative and multiple properties, as described in § 1.1031(k)-1(c)(4);
(5) No later than 180 days after the transfer of qualified indicia of
ownership of the property to the exchange accommodation titleholder, (a) the property is
transferred (either directly or indirectly through a qualified intermediary (as defined in §
1.1031(k)-1(g)(4))) to the taxpayer as replacement property; or (b) the property is transferred to a
person who is not the taxpayer or a disqualified person as relinquished property; and
(6) The combined time period that the relinquished property and
the replacement property are held in a QEAA does not exceed 180 days.
Permissible Provisions. The following are permissible provisions in a
An exchange accommodation titleholder that satisfies the
requirements of the qualified intermediary safe harbor set forth in §1.1031(k)-1(g)(4) may enter
into an exchange agreement with the taxpayer to serve as the qualified intermediary in a
simultaneous or deferred exchange of the property under § 1031;
The taxpayer or a disqualified person guarantees some or all of the
obligations of the exchange accommodation titleholder, including secured or unsecured debt
incurred to acquire the property, or indemnifies the exchange accommodation titleholder against
costs and expenses;
The taxpayer or a disqualified person loans or advances funds to
the exchange accommodation titleholder or guarantees a loan or advance to the exchange
accommodation titleholder;
The property is leased by the exchange accommodation titleholder
to the taxpayer or a disqualified person;
The taxpayer or a disqualified person manages the property,
supervises improvement of the property, acts as a contractor, or otherwise provides services to
the exchange accommodation titleholder with respect to the property;
The taxpayer and the exchange accommodation titleholder enter
into agreements or arrangements relating to the purchase or sale of the property, including puts
and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date
the property is acquired by the exchange accommodation titleholder; and
The taxpayer and the exchange accommodation titleholder enter
into agreements or arrangements providing that any variation in the value of a relinquished
property from the estimated value on the date of the exchange accommodation titleholder's
receipt of the property be taken into account upon the exchange accommodation titleholder's
disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of
funds from, the exchange accommodation titleholder.
Property will not fail to be treated as being held in a QEAA merely
because the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement
between the taxpayer and the exchange accommodation titleholder is different from the treatment
required by Rev. Proc. 2000-37.
Rev. Proc. 2000-37 is effective for QEAAs entered into with respect to an
exchange accommodation titleholder that acquires qualified indicia of ownership of property on
or after September 15, 2000.
Art as Spiritual Wealth.
Art is perhaps the most uplifting and exquisite form of expression known to humankind. Indeed,
the urge to create art in all its splendor has existed throughout human history. The oldest origins
of human society are accompanied by cave drawings, carvings in bone and wood, and often
dazzlingly exquisite forms of jewelry. Everything that is good and commendable about the
human spirit is ultimately expressed by and through art.
Art as Economic and Financial Wealth.
But simultaneously with its aesthetic value, art has also been a tangible and
important repository of wealth throughout human history. Art collectors, from museums to
private individuals, have paid huge sums to acquire the most prized and magnificent pieces of
Art, in turn, can appreciate in value over time – often quite dramatically. In his
book Picture This, author Joseph Heller notes that Rembrandt’s painting of “Aristotle
Contemplating the Bust of Homer” was purchased by the Metropolitan Museum of Art
(“MMA”) in New York City for $2.3 million in 1962, a then-record purchase price for a work of
art. Rembrandt himself created the painting in 1653, on a commission from Don Antonio Ruffo
of Messina, Sicily, who paid Rembrandt a fee of 500 Dutch guilders – an amount that Heller puts
into perspective by noting that Rembrandt lived in a house that cost 13,000 guilders. Today the
painting is estimated to be worth “well in excess of $100 Million” according to the Encyclopedia
of Art Education. That is just one of many famous examples of how art has appreciated
dramatically over a relatively short (What’s a few centuries among friends and art collectors?)
period of time.
The purpose of this booklet is to celebrate art for its aesthetic value, but also to
help art collectors better understand the complex and often arcane tax factors that come into play
when art is bought and sold or used as collateral for a loan. The objective is to provide art
collectors with strategic advice and practical ideas on how best to manage an art collection as a
unique and potentially lucrative economic asset, as well as a magnificent and pleasurable
aesthetic possession.
The Tax Cost of Selling Art Today.
Art collectors regularly reposition and upgrade their collections by selling
individual works of art and purchasing new works. Most collectors assume that these
transactions will be subject to federal and state income taxation if there is appreciation in the art
being sold – indeed, a work of art will often be put up for sale precisely because it has
appreciated dramatically in value.
A sale of a work of art can be extremely expensive from a tax standpoint.
Art is generally categorized as a “collectible” for U.S. federal income tax purposes, and therefore
the tax rate applied to gain on the sale of art – even if it has been held for more than one year – is
In addition, the sale will be subject to the Net Investment Income Tax (the
“NIIT”) which applies at a rate of 3.8% starting in 2013.
In addition, there are state and local income taxes as well, which can range
from 8.82% in New York state (and, with an additional 3.876% for New York City tax, the
combined rate is 12.696%), to 5.25% in Massachusetts, to California (12.3%).
In addition, if art is sold after it has been held for a year or less, the tax
rate is even higher. Short term capital gain’s are taxed at the selling individual’s marginal
federal tax rate on ordinary income, which can be 39.6% federally (and even higher when other
income tax adjustments are factored in), plus the NIIT, plus the state tax. In Massachusetts, the
short term capital gains tax rate – aberrationally – is 12%, even though the long-term capital
gains tax rate is 5.25%.
Example 1: A Taxable Sale of Art.
Assume that the owner of a significant art collection, Collector A, has
acquired a work of art for a purchase price of $10 million, and later decides to transfer the work
of art at a time when it can be sold at auction for $20 million. Collector A also wants to reinvest
the $20 million in expected proceeds by adding one or more other works of art to the collection.
If the original work -- called the “Relinquished Work” in the parlance of
Code Section 1031 -- is sold for $20 million, the taxpayer will have the following tax
Oil Painting #1
Tax Basis
Taxable Gain
Tax (35%1)
Net Proceeds available
for Reinvestment
Taxable Sale
Tax-Free Alternative – Like-Kind Exchanges.
There can be an attractive alternative – a tax-free alternative2 – for
structuring these art collection upgrade transactions. The purchase and sale of individual works
of art, if structured to meet the requirements of a like-kind exchange (a “Like-Kind Exchange”),
is eligible for non-recognition (tax-free) treatment under Internal Revenue Code §1031, and thus
can be implemented without triggering current federal income-tax liabilities.
state taxes as well.
Most states likewise recognize like-kind exchanges, and so it saves on
Example 2: Tax-Free Exchange of Art.
Assume the same facts as in Example #1, above, except assume that
Collector A structures the transaction as a Like-Kind Exchange. The sale contract for Oil
Painting #1 (the “Relinquished Work”) is assigned by Collector A prior to closing to a qualified
intermediary (a “QI”), and the $20 million net sales proceeds from the sale of the Relinquished
Work are then held by the QI and thereafter used by the QI (as directed by Collector A) to
acquire three new works of art (the “Replacement Works”) at a total cost of $20 million (i.e., the
total sum spent on Replacement Works equals or exceeds the net proceeds from the sale of the
Relinquished Work). Assuming this transaction meets the other requirements of a Like-Kind
Exchange, then Collector A will enjoy an estimated tax savings of $3.5 million that is reinvested
into the new works of art added to the collection.
This assumed effective tax rate of 35% would approximate a federal tax rate of 28% on collectibles, a
3.8% NIIT tax (also at the federal level), and a Massachusetts state capital gains tax of 5.25%, with a deduction on
the federal tax return to state taxes paid. If the sale were a fully taxable said in New York City of in California, that
effective tax rate would be significantly higher, and probably over 40%.
Technically, a Like-Kind Exchange results in tax deferral, meaning that the Relinquished Property is
exchanged for a Replacement Property, and Replacement Property has “carryover tax basis,” meaning that the buildin gain on the Relinquished Property is now transferred to the Replacement Property. However, if art is collected
over a lifetime, the built-in gain is deferred through the use of Like-Kind Exchanges, and the collector dies owning
the art, the built-in gain is eliminated by the step-up in tax basis on death under Code Section 1014 and the
transactions not only defer taxation for decades but eventually are truly “tax free.”
Oil Painting # 1 – Tax-Free
Tax Basis
Realized Gain
Recognized Gain
Net Proceeds available for
JBD3 Comment: The tax deferral illustrated in the foregoing example will
be even greater if Collector A is an astute art collector whose collection has appreciated
dramatically in value. In general, the greater the built-in value in the art collection, the more
substantial the benefit of a Like-Kind Exchange. Also note that the news works of art will, in
turn, have a carryover tax basis, i.e., $10 million of tax basis even though the collector invested
$20 million to acquire the replacement works. If the replacement works are later sold for $20
million, the collector will recognize $10 million of gain at that time – unless the collector
implements another Like-Kind Exchange!
Further JBD3 Comment: Although a properly implemented Like-Kind
Exchange can defer or reduce the federal income-tax costs, it may not necessarily avoid all other
taxes. For example, sales of art can be subject to state sales/use taxes. As will be discussed in
Part VII of this booklet, sales and use tax planning can be a very interesting and complicated
factor in structuring a Like-Kind Exchange of art.
Code Section 1031(a).
Code Section 1031(a) reads as follows:
“No gain or loss shall be recognized on the exchange of property held for productive use
in a trade or business or for investment if such property is exchanged solely for property
of like kind which is to be held either for productive use in a trade or business or for
Almost every word or phrase in this single sentence has important legal
implications, as will be carefully examined and discussed below.
JBD3 Comment: Like-kind exchange treatment is actually mandatory for
transactions that satisfy all the requirements of Code Section 1031. This has the odd and
sometimes important consequence that if a taxpayer engages in a qualifying exchange
transaction, the taxpayer will not be allowed to recognize gain or loss on the transaction, even if
the taxpayer would otherwise like to recognize the gain or loss. For example, if an exchange
transaction would otherwise generate a loss, it is often a desirable structure of the transaction so
that it does not qualify for non-recognition treatment under Code Section 1031. Be aware Code
Section 1031 can apply to one or both parties in an exchange transaction. It is especially
important to note that one party can be eligible for Code Section 1031 exchange treatment, even
if the other party to the transaction does not qualify.
Further JBD3 Comment: As will be discussed in greater detail below, the
vast majority of Like-Kind Exchange transactions (“LKE Transactions”) are structured as a
deferred like-kind exchange (a “Deferred Like-Kind Exchange”). In a Deferred Like-Kind
Exchange, the taxpayer typically hires a qualified intermediary or “QI” to facilitate a sale of one
property (called the “Relinquished Property”), and the acquisition of a replacement property
(called the “Replacement Property”), all in a manner that meets the technical “exchange”
requirements of Code Section 1031. As a practical matter, the taxpayer will in effect be selling
the “old” property and buying the “new” property in two separate transactions. However, thanks
to the “miracle” of Code §1031 and the use of a QI, the taxpayer will be treated as “exchanging”
the old property for the new property (with the QI as the counter-party to the exchange), even
though the QI is paid to act as the taxpayer’s de facto agent both for selling the Relinquished
Property and for acquiring the Replacement Property.
Basic Structuring Requirements.
To qualify for a Like-Kind Exchange under Code §1031, a work of art that
is being transferred as Relinquished Property must be (1) “held either for use in a trade or
business or for investment” immediately before the transfer, must be (2) “exchanged,” (3) the art
collector (called the “Exchanger” or simply the “Taxpayer”) must receive back “solely”
Replacement Property, (4) the Replacement Property must be of ‘like-kind” to the Relinquished
Property, and (5) the Replacement Property (i.e., one or more qualifying works of art) must
thereafter be “held either for use in a trade or business or for investment.”
Each of these five requirements will be discussed in further detail below.
Use of a Qualified Intermediary in a Deferred Like-Kind Exchange.
Although it is not absolutely mandatory, the vast majority of LKE
Transactions will be implemented through a “Qualified Intermediary” or “QI,” which is typically
a business organization – often a large and successful organization – that is engaged in the
business of facilitating Like-Kind Exchanges in return for a fee.
Picking a good QI is an important and often under-rated element of a
Deferred Like-Kind Exchange, because the QI can provide expertise in the tax steps required in
implementing the transaction, and at the same time can provide strong financial security while
the taxpayer’s funds are being held by the QI (including, as discussed more fully below, through
the use of a qualified escrow account or qualified trust account deposited safely in a major
money center bank). To explore these issues, further a good QI provides two extremely valuable
services in an art exchange:
Greater certainly that all the arcane requirements of a Like-Kind
Exchange are satisfied, because this is the QI’s dominant business. Although auction
houses and galleries can serve as the QI (under very specific and narrow circumstances –
be CAREFUL that the auction house or gallery is not a “disqualified person”), it is not
their dominant business (buying and selling art is their principal business) and so they
will almost inevitably be less experienced and sophisticated than a full-time professional
Financial safety and security, assuring that the funds received from the
sale of the Relinquished Property are handled in a secure, fiduciary manner, and are
always available to purchase the Replacement Property at the appropriate time. In a
recent matter that created a great furor in the New York art world, famous art collector
and Andy Warhol muse “Baby” Jane Holzer sued Stephan Stoyanov and his Manhattan
gallery for allegedly selling two of Ms. Holzer’s art works but then failing to close in a
timely manner on the two Richard Prince works designated as the replacement
properties in the exchange.
Sometimes, a taxpayer expressly requires that the exchange proceeds from
the sale of a Relinquished Property be held in a “Qualified Exchange Trust Account” which is a
special, segregated account held under a “Qualified Exchange Trust Agreement,” with a
fiduciary (e.g., a major money center bank trust company) acting as trustee to hold the exchange
proceeds. Similarly, the taxpayer can require the QI to place the exchange proceeds into a
“Qualified Escrow Account,” which is an escrow account typically held, again, with a major
money center bank as the escrow agent. There are nuanced differences between the Qualified
Trust Account and a Qualified Escrow Account, but as a practical matter the two are
substantially similar from the taxpayer’s perspective, and both provide terrific security that the
funds will be handled is a safe, fiduciary manner and will be segregated from all other funds,
including both the QI’s financial assets and other exchange funds being held by the QI for other
Simultaneous Versus Deferred Exchange Structures.
A Taxpayer can implement a so-called “simultaneous exchange,”
pursuant to which the taxpayer exchanges art works directly with another art collector without
engaging the services of a QI. However, to do so the Taxpayer must find a counter-party who
(1) wants the art work the Taxpayer is seeking to transfer, (2) the counter-party has one or more
works of art that the Taxpayer wants in return, and (3) the dollar values match up such that the
Taxpayer does not receive cash or other consideration (other than qualifying like-kind property)
in the exchange.
In the real world, it is difficult (although not impossible) to implement a
simultaneous exchange, and so it is far more common for a Taxpayer to implement a Deferred
Like-Kind Exchange. This structure allows the Taxpayer to sell an art work to a buyer that
wants to purchase the Relinquished Property for cash, and then, through the QI, uses that cash to
purchase one or more Replacement Property(ies) from one or more sellers, which sellers can be
(and usually will be) unrelated to the buyer of the Relinquished Property and to each other (if
more than one work of art is acquired on the replacement leg of the exchange transaction).
JBD3 Comment: Thanks to the favorable and flexible Deferred Like-Kind
Exchange rules contained in the Regulations, a Taxpayer can implement a Like-Kind exchange
in the following discrete steps:
an unrelated purchaser;
use an art auction or gallery to dispose of his or her work of art to
have the QI directly receive the proceeds and hold the proceeds for
a period of time (probably in a qualified trust or qualified escrow, as described above),
identify desirable replacement property, subject to the
Identification Rules discussed more fully below (generally, property must be identified within 45
days of the sale of the relinquished property and closed within 180 of such sale);
direct the QI to use the proceeds from the relinquished property
sale to acquire one or more new works of art within the applicable 180 Replacement Period
(discussed more fully below); and
have the QI direct that the art be delivered to the taxpayer at the
proper time, and in the proper manner and location (this can have major sales and use tax
consequences, as discussed below).
Moreover, the Taxpayer can engage a accommodator (typically an affiliate
of the QI) to acquire the Replacement Property (or Replacement Properties) even before selling
the Relinquished Property, in a so-called “Reverse Exchange,” so long as certain timing,
identification and other requirements are met.3
The Deferred Like-Kind Exchange rules are very flexible in certain key
respects, although, as we will discuss below, these rules can also be very technical and rigid in
other respects. The requirements to implement a Deferred Like-Kind Exchange are discussed in
detail below, in Part V of this booklet.
Recognition of “Boot.”
The language of Code Section 1031(a) states that the Taxpayer must
transfer the Relinquished Property “solely” in exchange for eligible Replacement Property, but in
fact a Taxpayer can accept some cash (or other non-qualifying property) as part of a Like-Kind
Exchange, although this non-qualifying property (referred to as “Boot”) will trigger gain to the
extent of the fair market value of the Boot (up to the maximum amount of gain realized in the
exchange transaction).
Example 3: Boot Rules.
Assume the same facts as in Example 1, above, except that instead of purchasing a replacement
work of art worth $20 million, Collector A (through the QI) purchases a replacement work of art
worth $17 million and keeps $3 million from the sale of the Relinquished Property. In that case
See Rev. Rul. 2000-37 for the specific details of how to structure a “reverse exchange.”
the amount of Boot is $3 million, and so Collector A recognizes $3 million of gain and will owe
taxes of $1,050,000 ($3,000,000 X 35% tax rate).
Example 4: Boot Rules.
Same facts as in Example 3, except that Collector A only identifies and purchases $8 million of
Replacement Property. The amount of Boot is $12 million ($20M - $8M), and this exceeds the
amount of gain realized on the transaction ($10M), and so the amount of gain is capped at the
amount realized, namely, at $10 million. Collector A has $10 Million of taxable gain, and will
owe taxes of $3.5M ($10,000,000 X 35% tax rate). Note that even though Collector A acquired
$8 Million of eligible Replacement Property in this transaction, all the realized gain is
recognized, the same as if Collector A has sold the Relinquished Property for $20M in Example
1 and made no effort to reinvest in works of art. This illustrates that under the Boot rules all gain
is recognized first. This is an area where the Like-Kind Exchange rules are far from being
entirely “taxpayer friendly.”
One of the key phrases in Code Section 1031(a)(1), used not once but
twice, is the requirement that both the Relinquished Property and the Replacement Property must
be “held for productive use in a trade or business or for investment…”
This phrase, in turn, can be broken down into two components:
That the property must be “held,” and
That the property must be held for “productive use in a trade or
business or for investment.”
Held Requirement.
The “held” requirement means that property is not eligible for Code
Section 1031 treatment if it is acquired solely to facilitate an exchange or otherwise is acquired
for immediate transfer in a second transaction. See Rev. Rul. 75-292, 1975-2 C.B. 333 (an IRS
ruling that property acquired in a Section 1031 transaction and immediately contributed to a
corporation under Code Section 351 is not “held” for a qualified purpose). As Rev. Rul. 75-292
indicates, the IRS takes the very clear (but arguably wrong) position that there is an implicit time
period for which property must be “held” before or after an exchange in order to be eligible for
non-recognition under Section 1031. The good news is that the IRS has regularly lost all of the
cases in which it has litigated the “held” requirement.4
NOTE: This “held” requirement is sometimes important when real
property is owned in a partnership, e.g., if partners want to distribute property out to themselves,
so that some can engage in a like-kind exchange while others simply sell the assets in question.
This is known in the real estate world as a “drop and swap” transaction. In the art world, the
held requirement is probably not likely to be as significant or to arise as often as it does in the
real estate industry.
Used in a Trade or Business or for Investment.
The second component of this requirement, whether the art in question is
held “for productive use in a trade of business or for investment,” is far more challenging and
First of all, art in the hands of an individual collector will be characterized
for federal income tax purposes as falling into one of three general categories:
it may be characterized as a “personal asset,” meaning it is held
for personal purposes, similar to a personal residence, and is not held for business or investment
it may be characterized as an “investment asset,” meaning it is
held predominantly for investment purposes; and
it may be characterized as a “business asset,” meaning that it is
held for productive use in the owner’s trade or business.
The second and third categories described above will be eligible for
exchange treatment under the Like-Kind Exchange Rules, while the first category will not be
eligible for exchange treatment.
Art Can Be a “Business Asset” – But Probably Not in Your Case.
Although it is not the most common status, it is clearly possible for art to
be a “business asset.” For example, many businesses display or hang art in the lobby of their
offices, or on the business premises, because art creates a special emotional mood of
sophistication and elegance, and because, successfully displayed, art conveys a positive business
image equal or superior to almost any other form of advertising and marketing. In general, art
owned and displayed by a corporation or other business entity will very likely fall into this
category of “business art.”
On the other hand, an art dealer is clearly engaged in a trade of business,
but the art works are held as “inventory” rather than as “business assets” in the hands of the art
dealer, and therefore generate ordinary income on sale and, more importantly for the purposes of
this booklet, are not eligible for like-kind exchange treatment. See Code Section 1031(b)(1).
For most individual art collectors, however, the art they own and hold is
likely to be either a personal asset (with generally unattractive income-tax attributes) or an
investment asset (with much more attractive income-tax attributes). The factual distinctions
between falling into one or the other of these two categories, at least in practical terms, is likely
to be surprisingly small and deeply nuanced. However, these small and nuanced differences
must be treated seriously and addressed carefully, because they will determine whether the art is
a “personal asset” or an “investment asset,” and thus whether or not it is eligible for a variety of
favorable income-tax results, including whether it is eligible to be exchanged in a Like-Kind
Art Held as Inventory.
Art in the hands of an art dealer, i.e., a person who buys and sells art as
inventory, would be considered an “ordinary” asset and would generate ordinary income (or loss)
on resale. Art in the hands of an art dealer is not eligible for Like-Kind Exchange treatment.
Code Section 1031(b)(1). This booklet is focused on the tax attributes of art held by art
collectors, not by art dealers, and so this discussion is limited.
There is, however, a tension between a collector trying to prove that art is
held for investment (rather than personal) purposes, and accidentally proving too much, i.e.,
demonstrating so much business and profit motivation that it becomes inventory in a business.
This issue came to the fore in Graham D. Williford, TC Memo 1992-450,
a case that pre-dates the special 28% federal tax rate on collectibles. the taxpayer in question
was a part-time art dealer who also sold paintings from his personal collection. The IRS argued
that the taxpayer was a “dealer” and that the sales from his personal collection were subject to
tax at ordinary income tax rates. The court found that the taxpayer sold four paintings in each of
the two years at issue and was influenced by the fact that the profits from the sales represented
capital appreciation from holding the paintings for substantial periods (between 13 and 19 years).
The taxpayer kept his personal collection separate from his dealer inventory, and established that
he did not purchase his private collection with the intent to resell the paintings. The taxpayer
advertised only one of the paintings in his personal collection for sale, and was approached by
unsolicited offers for the other paintings. The court also noted that the taxpayer did not use the
sales proceeds to replace the property sold, and used some of the proceeds to buy a new
In Thomas B. Drummond v. Commissioner, TC Memo 1997-71, the facts
were very strange. The taxpayer sold a valuable painting in 1989 and tried to claim the income
as “ordinary income” on his tax return, because (if permitted) it would allow the taxpayer to
claim various deductions under a SEP plan, while if characterized as capital gain the deductions
for the SEP plan would be disallowed and the taxpayer would be subject to onerous penalties for
excess plan contributions.
The facts in the Drummond case related to the sale of the art work were as
During the 1970's, petitioner, who at all relevant times has had an
interest in and enjoyed art, purchased at least six drawings through auctions, galleries, or private
sales, including one entitled “Three Feminine Heads” (drawing in question) that he purchased
during the early 1970's for $1,300 from a gallery in Washington, D.C., and that had been
attributed to the artist Michelangelo Anselmi (Anselmi). When petitioner acquired those
drawings, he did not intend to sell them. Drawings of the type that petitioner purchased had often
been used by their respective artists as models for their own paintings, sculptures, and/or frescos.
Petitioner conducted research throughout the 1970's and into the
1980's on the drawings that he had acquired during the 1970's. As a result of that research,
petitioner concluded that certain drawings of the type that he had purchased either were not
attributed to particular artists or were attributed, as was subsequently determined was the case
with the drawing in question, to the wrong artists and that art museum curators knowledgeable
about both museum and privately-owned art collections were qualified to determine the artists of
such drawings.
Around the early 1980's, based on a visual comparison of the
drawing in question with drawings properly attributed to Anselmi, petitioner became convinced
that Anselmi had not sketched that drawing; the curator of Italian drawings at the National
Gallery (curator of Italian drawings) became interested in the drawing in question; that curator
advised petitioner that she was fairly certain that the drawing in question was attributable to a
follower of Correggio, who worked, as did Correggio, in Parma, Italy, during the 16th century;
petitioner lent that drawing to the National Gallery; and the curator of Italian drawings conducted
research on it and attributed it to a [pg. 412] follower of Correggio named Franco Parmagianino
For some undisclosed period of time after the drawing in question
was attributed to Parmagianino, the curator of Italian drawings caused the drawing in question to
receive international exposure by having it displayed in art exhibits at the National Gallery and
in Parma, Italy. During that period, that drawing also received international exposure through
newspaper articles about it in the United States and Italy and photographs of it in museum art
During 1988 or 1989, Christie's Auction House in New York City
(Christie's) advised petitioner that the drawing in question could be sold at auction for
approximately $100,000 and expressed an interest in auctioning it on his behalf. At or about the
same time, the curator of Italian drawings informed petitioner that the National Gallery was
interested in purchasing that drawing. Petitioner advised her that Christie's could sell the drawing
in question at auction for $100,000 and that he would be willing to sell it to the National Gallery
for an amount exceeding $100,000. Thereafter, petitioner received a letter from the National
Gallery offering to purchase the drawing in question for $115,000. In January 1989, petitioner
sold it to that museum for that amount.
During all relevant periods, petitioner did not own or acquire any
drawings, other than the drawing in question, that were either unattributed or misattributed and
for which proper attribution was obtained. During the 1970's, petitioner did not attempt to sell
any of the drawings that he had acquired during those years. During the period 1985 through
1994, petitioner did not sell any artwork or collectible, other than the drawing in question. After
the sale of the drawing in question, petitioner did not use the proceeds from its sale to purchase
other drawings for purposes of attribution and sale.
The court in Drummond held against the petitioner’s position, and
provided the following explanation and analysis:
“Based on our review of the entire record before us, and in particular the
following facts, we find that petitioner has failed to establish that he held the drawing in
question primarily for sale to customers in the ordinary course of his trade or business
within the meaning of section 1221(1): (1) When petitioner acquired the drawing in
question during the early 1970's, he did not intend to sell it; (2) petitioner conducted
research throughout the 1970's and into the 1980's on the drawings that he had acquired
during the 1970's; (3) during the 1970's, petitioner did not attempt to sell any of the
drawings that he had acquired during those years; (4) petitioner did not sell any artwork
or collectible, other than the drawing in question, during the period 1985 through 1994;
18 (5) petitioner purchased the drawing in question during the early 1970's and had it
attributed to the correct artist around the early 1980's, but did not sell it until January
1989; (6) petitioner did not use the proceeds from the sale of the drawing in question to
purchase other drawings for purposes of attribution and sale; and (7) petitioner engaged
in a psychology practice during all relevant periods, the income from which provided his
support during those periods.”
JBD3 Comment: These two cases, Williford and Drummond, illustrate
that there is a continuum in the world of art collecting. A collector can be viewed as collecting
art primarily for personal private reasons (in which case the collector cannot engage in a LikeKind Exchange); the collector can be viewed as collecting art primarily for investment purposes
(and can engage in Like-Kind Exchanges); or the collector can buy and sell are so regularly and
continuously that the art collecting becomes a business itself (and the art become inventory and
therefore is not eligible for Like-Kind Exchange treatment).
JBD3 Comment: The cases above are included in this booklet in part
because there is almost NO OTHER AUTHORITY on these key issues, and so these cases at
least illustrate how a court might look at a specific collector’s actions and attitudes in reaching a
conclusion on these vital issues.
Tax Treatment of Art Held as an Investment Asset.
A work of art held as an “investment asset” will be subject to capital gain
treatment (and probably subject to the special 28% tax rate on collectibles, discussed below) or
subject to capital loss treatment, on sale. If held for more than one year, the gain will be longterm capital gain or loss (again, subject to the special 28% tax rate on collectibles). If held for
one year or less, the sale will result in short-term capital gain or loss. Expenses incurred to own,
hold, preserve and maintain the works of art held for investment will be treated as investment
expenses and will generally be subject to deduction under Code Section 212.
Art held as an “investment asset” will be characterized as a “collectible,”5
and, if held for more than one year, any gain recognized on the sale of the artwork will be subject
to a special capital gains tax rate under Code Section 1(h)(5), which tax rate is currently 28%.
Collectibles are defined under Code Section 408(m)(2).
“Collectibles” for purposes of applying this special tax rate include 1) any work of art, 2) any rug
or antique, 3) any metal or gem, 4) any stamp or coin, 5) any alcoholic beverage, or 6) any other
tangible property specified by the Secretary for purposes of this subsection.6
Art is always in the eye of the beholder, but it is significant to note that the
phrase “work of art” is not defined in the Internal Revenue Code. Indeed for purposes of
applying the special 28% tax bracket for collectibles, there is some question as to what
constitutes a “work of art.” For example, it is generally assumed that a painting or sculpture
would clearly come within the intended scope of this definition, but it is less clear whether, for
example, whether a book of poems should be included.
Brief Discussion of Precious Metals as “Collectibles.”
Precious metals are an important subset of the collectibles world. For
purposes of applying this special 28% tax rate, collectibles include any coin which is a gold coin
minted by the United States Government, any silver coin minted by the United States
Government, any platinum coin minted by the United States Government, any coin issued under
the laws of any state, and any gold, silver or platinum or platinum bullion of a fineness that is
equal to or exceeding the minimum of fineness that a contact market requires for medals which
may be delivered in satisfaction of a regulated futures contract.
As a passing observation that will be discussed more fully later in this
booklet, note that this last category of assets can in fact be held in an individual retirement
account or by an individual directed account, while other collectibles cannot be held in these
Tax Treatment of Art Held as a Personal Asset.
Art held as a personal asset will have the least favorable tax attributes and
tax consequences. Like a personal residence or other personal asset, art held as a personal asset
will be subject to tax (at the tax rate on collectibles) if it is sold at a gain, but will not produce a
deductible loss if sold at a loss, as a result of Code Section 262.7
Gain on sale, on the other hand, will be subject to tax at the special 28%
tax rate assessed on “works of art” identified as collectibles.8
Establishing that Art is Held for Investment – the Wrightsman case.
At the present time, the Secretary has not specified any additional property.
Section 262(a) reads as follows: “Except as otherwise expressly provided in this chapter, no deduction
shall be allowed for personal, living, or family expenses.”
The term “collectibles” originates in Code Section 408, and was originally created to bar taxpayers from
using an IRA to invest in and accumulate “collectibles.” It appears that the special tax rate on collectibles applies
whether the art work in question is held as an “investment asset” or as a personal asset, since personal assets
generate capital gain on sale (but not a deductible loss if sold at a loss). A related question is whether, if art is held
as a personal asset, gains and losses can be netted. In general, Code Section 262 forbids deductions or losses from
the sale of a personal asset, e.g., the principal residence. However, Code Section 183, governing “hobby losses”
does allow losses from a “hobby” to be used to offset income from the hobby. It seems logical that art collecting at
the very least would be considered a “hobby” subject to the hobby loss rules under Code Section 183.
Overview of Wrightsman Case -- The “Too Much Fun” Doctrine.
There is a rather remarkable and perhaps telling paucity of
guidance9 on whether and under what circumstances art can qualified as “held for productive use
in a trade or business or for investment.” One of the rare cases on this issue is Wrightsman v.
US,10 a very curious case in several respects. Wrightsman was brought in the US Court of
Claims, and also involved Code Section 212 (related to whether expenses incurred in connection
with an art collection were deductible by the taxpayer as expenses incurred in connection with an
activity carried on for profit) rather than under Code Section 1031. However, the similarity of
the factual issues and related standards between Code Section 212 and Code Section 1031
suggest that Wrightsman is useful and appropriate guidance for art collectors trying to qualify
their activity as an “investment” activity for purposes of Code Section 1031.
In Wrightsman, the issue before the Court involved the
deductibility under Code section 212 of certain expenses incurred by plaintiffs with respect to
their art collection. Deductibility of such expenses under section 212, in turn, depended upon
whether plaintiffs collected the pertinent works of art primarily as investments or, instead,
primarily for their personal pleasure and enjoyment. The Court held that plaintiffs have failed to
establish that their art collection was primarily investment-motivated and, therefore, they were
not entitled to recover. Amazingly enough, the court noted that the Wrightsmans were clearly
experts in art – and held that against them! The court opinion is long-winded and sermonizing,
but the conclusion can be summarized as follows: The Wrightsmans were having too much fun
for this to be anything besides a “personal” activity, however, professionally and profitably it
was run. In this booklet, we will refer to this (sardonically) as the “Too Much Fun Test.”
Detailed Summary of Facts in Wrightsman Case.
The Wrightsmans' were a married couple and their acquisition of
works of art commenced in 1947 when their expenditures for art objects amounted to $3,741. By
the end of 1960, their purchases totaled $5.2 million and, by the end of 1961, $300,000 more. As
of March 31, 1967, plaintiffs' total purchases of works of art exceeded $8.9 million; the works of
art were valued for insurance purposes in excess of $16.8 million.
Mr. Wrightsman had formed the belief that works of art were an
excellent hedge against inflation and devaluation of currencies, that they represented portable
international currency, since there were no restrictions on export from the United States, and that
works of art were appropriate assets for investment of a substantial portion of his surplus cash
being generated. These beliefs and investment intent were expressed to numerous friends and
associates and the employees of his business office.
In their art collecting activities, plaintiffs have specialized in the
acquisition of 18th century French works of art. Mrs. Wrightsman was not just a nominal party
The IRS, in a document issued in 1992, indicated that it has no interest in determining whether art was
held for investment, except in audits on a case-by-case basis. This type of approach is relatively common for the
IRS in areas where it is afraid that clear guidance will lead to more aggressive taxpayer conduct and reporting
positions. [Talk about Economic Substance Doctrine – and “Don’t Ask, Won’t Tell”].
192 Ct. Cl. 722 (1970).
herein because of the filing of joint returns by the parties. She owned about three-fourths of
plaintiffs' works of art, either by number or by value. Their activities in the acquisition and
holding of such works of art had been conducted jointly.
The Wrightsmans constantly associated with well known experts in
the art world. They were recognized as art experts in their own right, as supported by the
testimony of Mr. Francis J. B. Watson, Surveyor of the Queen's Works of Art and Director of the
Wallace Collection of London, and Mr. Joseph V. Noble, Vice Director for Administration of the
Metropolitan Museum of Art.
In the acquisition by plaintiffs of works of art, each art object had
been invoiced, assigned an inventory number, and noted as an approved purchase by one of the
plaintiffs. The invoice was sent directly to plaintiffs' Houston, Texas, business office for
payment. There the approved invoice was checked for accuracy, and a check request was
prepared, following the usual business procedures employed in Mr. Wrightsman's investments in
oil and gas properties. The check request, a copy of the check, and a copy of the original invoice
are retained in the Houston office file. The original invoice, marked paid, with date and check
reference, is returned to plaintiffs' personal files, which follow them from the Palm Beach home
to their New York apartment, as the occasion warrants. Each item is reflected in the investment
control account of the general ledger maintained in the Houston office. A detailed investment
card record is kept with respect to each item in the works of art collection. On each card is noted
the original purchase price, the date of purchase, and any items deemed to be of a capital nature
requiring capitalization on the investment books of plaintiffs.
Plaintiffs have consistently catalogued their purchases of works of
art. At the time of the trial herein, these catalogues consisted of 26 three-ring binder volumes,
requiring a shelf space of about five feet. These catalogues are unique, represent 20 years of
work by Mrs. Wrightsman, and have considerable value. Partially on the basis of this extensive
cataloguing, the Metropolitan Museum has published two volumes and is in the process of
completing the publication of a five-volume work on the Wrightsman Collection, authored by
Mr. Francis J. B. Watson, which will be a treatise on 18th century French works of art.
On their Federal income tax returns for the years 1960 and 1961,
plaintiffs claimed deductions for certain ordinary and necessary expenses incurred in the
management, conservation and maintenance of investment properties, i.e., works of art, held by
them for the production of income, and incurred in the production and collection of income from
those properties. These expenses, which were incurred in connection with, and are directly
attributable to, plaintiffs' works of art, represent costs of insurance, maintenance, subscriptions
and services, shipping, hotel, travel, entertainment and other miscellaneous expenses. Plaintiffs
also claimed as deductions on their 1961 return the alleged cost of acquiring and subsequently
releasing a painting due to the inability to obtain an export permit, and part of an alleged capital
loss sustained on the sale of certain works of art. Disallowance by the Internal Revenue Service
of the claimed deductions, and denial of plaintiffs' claims for refund of the paid deficiencies
issuing therefrom, gave rise to the suit.
Court’s Discussion of Law and Facts.
In analyzing the Wrightman case, the Court stated as follows:
“It is clear from the above that the burden of proof which plaintiffs must satisfy if they are to
prevail is that as a factual matter, from an objective view of the operative circumstances in suit,
they acquired and held works of art during the years here involved primarily for investment,
rather than for personal use and enjoyment. Plaintiffs must establish that their investment
purpose for acquiring and holding works of art was "principal," or "of first importance." See,
Malat v. Riddell, 383 U.S. 569, 572 [17 AFTR 2d 604] (1966). And, they must establish this
notwithstanding the pleasure-giving quality commonly recognized as inherent in art objects.
“Plaintiffs have carefully marshaled a broad array of evidence in support of their declared
investment purpose. In this regard, we have no reason to doubt that Mr. Wrightsman was wary of
the more traditional forms of investment, or that he recognized an investment-aspect incident to
the acquisition and retention of works of art. Indeed, the greatly increased current value of the
Wrightsman collection would seem, at least in retrospect, to confirm the financial wisdom of
plaintiffs' purchases. Nor do we doubt that meticulous bookkeeping detail was observed by
plaintiffs with respect to the purchase, care, and maintenance of their collection, or that the
Wrightsmans devoted considerable time and effort to their collection activities. We fully
appreciate, moreover, that because of plaintiffs' mode of living, much of their time was spent
away from their residences wherein the majority of their works of art were maintained. It is our
judgment, however, that this evidence, when viewed in proper relationship to the additional
evidence below, relegates investment intent to a position of something less than primary among
plaintiffs' purposes for acquiring and holding works of art.[Emphasis supplied.]
“It may fairly be said, and the record so indicates, that plaintiffs' personal lives revolve around
their art collection and related collecting activities. The Wrightsmans, without any prior formal
education with respect to works of art, have since the late 1940's consistently and diligently
pursued a course of self-education in that field, visiting major museums and art dealer
establishments in the United States and overseas, studying works of art themselves, reviewing
auction catalogues and price lists, and engaging in discussions with recognized art experts, such
as collectors, museum curators, dealers and others knowledgeable in the world art community.
They have reviewed all of the leading art periodicals, and engaged in extensive reading in their
chosen field of 18th century French art and related areas. They have acquired a substantial art
library, and Jayne has engaged in extensive research, while Charles has concentrated on the
restoration and conservation of art objects and the conditions of the art market. Jayne has
educated herself in the use of the French language, to be qualified to engage in discussions and
reading of materials in that language concerning 18th century French furniture and works of art.
Whether in Palm Beach, New York, or abroad, the major portion of the Wrightsmans' day-to-day
activities throughout each year is devoted to studying works of art. And, the Wrightsmans' social
life in Palm Beach, New York, or abroad involves principally people knowledgeable and
interested in the field of art.
“As to the place and manner in which the Wrightsmans have held their collection, the record
reveals that, except for occasional displays of items at other locations, plaintiffs have kept their
works of art in their New York apartment, their Palm Beach home, and in the Metropolitan
Museum on loan for display by that institution. As of March 31, 1967, about 77.8 percent of such
objects (on an insurance evaluation basis) was in the New York apartment, about 17.7 percent in
the Palm Beach home, and about 4.5 percent in the Metropolitan Museum. The works of art are
on display, or in use as in the case of such items as French period furniture, in the New York
apartment and the Palm Beach home, except that a small amount of furniture is stored in one
room at Palm Beach.
“Plaintiffs have provided air conditioning and humidity controls, considered necessary for the
preservation of works of art, similar to those employed in the Metropolitan Museum. In this
respect, the New York apartment is better equipped, accounting for the concentration of works of
art there. Such apartment occupies the entire third floor of the building. Storage facilities for
works of art have not been readily available to provide the required atmospheric controls
especially needed for paintings and furniture.
“The record also reveals extensive personal use by the Wrightsmans of various parts of their
collection. 18th century oriental wallpaper had been installed by the previous owner on the walls
of plaintiffs' Palm Beach residence which had been acquired as a completely furnished home.
18th century French parquet flooring has been installed by plaintiffs in their Palm Beach home,
and in their New York apartment. Plaintiffs' paintings are never stored but, instead, a limited
number are hung on the walls of their Palm Beach home, with most of them on the walls of their
New York apartment. Mr. Wrightsman's bedroom in their apartment is furnished with 18th
century French furniture and fixtures, and his bedroom in their Palm Beach home contains a
French commode. Mrs. Wrightsman's bedroom in their apartment is furnished completely with
Louis XV matching furniture and fixtures. Plaintiffs' apartment also has other rooms which
contain other works of art from their collection in the form of matching furniture and furnishings.
“In sum, what we wish to make clear from the foregoing is that we recognize as established an
investment purpose for plaintiffs' collection. To be sure, many of the above-detailed facts and
circumstances are entirely consistent with investment intent. On balance, however, the evidence
does not establish investment as the most prominent purpose for plaintiffs' acquiring and holding
works of art. The complete record does establish, to the contrary, personal pleasure or
satisfaction as plaintiffs' primary purpose.
“Plaintiffs place much reliance upon George F. Tyler, supra, wherein a loss sustained on the sale
of part of a stamp collection was held deductible under section 23 of the 1939 Internal Revenue
[pg. 70-5137] Code as having been incurred in a transaction entered into for profit. The precise
factual issue before the court was whether the stamp collection was held primarily for profit or
primarily as a hobby. In finding the former purpose to be primary, the Tax Court emphasized that
the taxpayer from the outset undertook stamp collecting as an investment; that he consummated
all purchases through a professional philatelist, who stressed the investment feature of stamps;
that he purchased stamps only upon the philatelist's recommendation; that he exhibited scant
interest in or knowledge of stamps; and that he participated little in those activities generally
associated with stamp hobbyists. Thus it was found that although the collection and possession
of stamps afforded the taxpayer some pleasure, such activities were undertaken primarily for
“The great disparity in facts and circumstances between Tyler and the instant case compels the
conclusion, we think, that the Tyler decision in no sense advances plaintiff's current cause The
actual importance of the Tyler case, for our purposes, lies in the standard there applied:
“*** The difficulty, then reduces itself to the task of ascertaining whether petitioner has
sustained his burden of proving that the desire to make a financial profit was the most important
motive which led him to acquire the components of his collections. [6 TCM at 280]”
“The Tax Court determined, in the factual context of the Tyler case, that the taxpayer had
sustained his burden of proof. We hold, in the factual context of the case before us, that the
instant plaintiffs have not.”
JBD3 Comments on Wrightsman Case.
The Wrightsman case is both frustrating and disturbing because it
is clear that the Wrightsmans were serious, dedicated art collectors, and in the end the court
seemed to hold that fact against them, concluding that, while investment was clearly a factor in
their decisions to buy and hold art, that “personal pleasure or satisfaction” was their primary
purpose. In other words, the Too Much Fun Test.
It is a very fair question to ask whether the Wrightsman case was
properly decided. The taxpayers’ handling of the art collection was professional and businesslike in all respects, and it was clear that, while they displayed their art works in personal
residences (when it was not on loan to the Metropolitan Museum) they also travelled extensively
and the art, obviously, stayed put.
Wrightsman strongly suggests that a prudent art collector
interested in enjoying the benefits of Code Section 1031 should maintain the art collection with
the same professionalism and business acumen, but should consider showing a little less
exuberance in the personal enjoyment or art. Tax Recommendation: DON’T Have Too Much
How to Demonstrate that You Are NOT Having Too Much Fun.
The following are some thoughts on how you can demonstrate the requisite “investor”
attitude while engaged in the thoroughly enjoyable business of collecting art:
An art portfolio that is stored in a temperature-controlled
environment that emphasizes preservation over viewing enjoyment would almost certainly avoid
the “too much fun” component that was fatal for the Wrightsmans.
Similarly, it would seem that a pretty strong argument in favor of
investment status would exist if the art is placed on loan to an art museum where the “personal”
enjoyment is greatly reduced and the costs of the art ownership are borne or otherwise defrayed
by the museum.11
NOTE: An interesting issue is whether the “costs” of preservation and maintenance borne by the
museum are a “payment in kind” to the taxpayer; this would actually be a GOOD argument, namely that the
taxpayer has income (preservation and maintenance expenses borne by the museum) and an offsetting deduction
(presumably under Code Section 212) for maintenance. All of this would tend to support the position that the art is
an investment asset, not a personal asset.
Consulting outside investment advisors seems to be evidence of an
investment intent, although this element of the Wrightsman case is particularly obnoxious in my
personal opinion. The Tyler case cited in Wrightsman, involving stamps, seems a odd (and
oddly aligned) counterpoint to the Wrightsman case, and there should be nothing wrong with
enjoying your investment activities.
The “exchange” requirement would, on its face, seem to be a pretty
important element to a transaction called a “like-kind exchange” but in fact very few modern
exchanges occur simultaneously and directly between two parties. Rather, thanks to the socalled “Starker” regulations adopted in 1991, almost all modern “exchanges” occur on a nonsimultaneous basis, with either the Relinquished Property or the Replacement Property acquired
first, and the other property transferred latter.
The key element that makes this work is the Qualified Intermediary or QI:
The QI engages in an “exchange” with the Taxpayer (who is a customer of the QI), whereby the
Taxpayer transfers the Relinquished Property to the QI, who in turn transfers it to the buyer
(unusually, though not always, an unrelated party), and the QI is then contractually obligated to
acquire and transfer back to the Taxpayer other like-kind property to complete the exchange.
Starker Regulations.
The Starker regulations were an outgrowth of the famous Starker12 case,
where a taxpayer transferred real estate and eventually received back (some five years later) the
replacement property. The ensuing court case upheld the transaction as an exchange, and, after
some indecision the IRS supported an amendment to Section 1031 that provides for a so-called
“Deferred Like-Kind Exchange” where the Replacement Property is identified within 45 days of
the transfer of the Relinquished Property, and the replacement transaction is closed within 180
after the transfer of the Relinquished Property.
The qualified intermediary must be a very responsible party that has
integrity, bonding and has the ability to hold fairly large sums of money for a period of up to 180
days. To do a like kind exchange where property is sold and other property is acquired, one
typically locates a buyer, and sells the work. Within 45 days after the sale, a party must identify
replacement properties, and then must move relatively quickly to close within 180 days.
NOTE: 180 days sounds like a lot of time until you are actually in the process of trying
to find replacement property, and then it seems like almost no time.
The regulations have fairly detailed and stringent rules about engaging a
QI, entering into an Exchange Agreement, assigning the contracts to sell the Relinquished
Property and buy the Replacement Property, how identification occurs, how many properties you
can identify, and other criteria, but a qualified intermediary will be able to walk you through that
process pretty effectively. In general, you are allowed to identify up to three properties of any
value (the “Three-Property Rule”) to replace a single property that has been transferred, or you
are allowed to identify as many properties as you want up to the maximum value of 200% of the
property that was transferred (the “200% Rule”).
These identification rules raise some interesting issues in an art exchange:
For example, if you have a property that sold to an auction for $50 million, you can either
identify up to three potential Replacement Properties with a total value of whatever you want, or
you can identify as many potential Replacement Properties as you want, but a value cannot
exceed $100 million.
Because the exact value of any potential Replacement Property is hard to
know with certainty, it is difficult to implement with certainty into the 200% Rule. A lot of
people prefer the Three-Property Rule to the 200% Rule, just because you can be exactly sure
that you have met the identification requirements. On the other hand, if you are selling a large,
valuable piece and would like to buy multiple pieces to replace it, the 200% Rule is probably the
better option. For example, the author recently helped structure a like kind exchange where a
valuable and world famous art piece was sold for an amount in the range of approximately $50
million, and the money was reinvested in three other pieces by another world famous artist.
Definition of “Like-Kind” Property for Exchanges of Art.
When a like-kind exchange involves real estate, the definition of “like
kind” property is extremely broad and the regulations treat all real estate as “like kind” with all
other real estate. Reg. Section 1031(a)-1(b). Also, a leased real property where the lease is for a
period of 30 years or more is considered “like-kind” to an actual ownership interest in real estate.
Reg. Section 1.1031(a)-1(c). Under these rules, the Empire State Building in Manhattan is “like
kind” to a three-decker in Watertown, which is like-kind to 160 acres of Iowa farm land, and all
of which are like-kind to an operating interest in an oil well (which is defined as an interest in
“real estate” under the state law of many oil-producing states).
As a practical matter, like-kind exchanges of real estate are much easier to
implement than exchanges of tangible or intangible assets, including all art and other
collectibles. Indeed, outside of the real estate area, the characteristics and attributes that make for
“like-kindness” have always been surprisingly vague and sketchy. Part of the problem is that the
IRS guidelines and standards that define what constitutes “like kind” have always been
amorphous and full of language that, if not entirely circular, is at the very least far from clear.
Under Code § 1031(a), the words “like kind” refer to the” “nature or
character of the property, and not its grade or quality.”13 One kind or class of property may not
be exchange for property of a different kind or class.14 The Regulations state the generic
principle that personal properties that are determined to be of “like class” are considered to be of
See Reg. Section 1.1031(a)-1(b).
Reg. Section 1.1031(a)-1(b).
“like-kind” for Code Section 1031 purposes.15 In addition, an exchange of like-kind property
qualifies for non-recognition even if the properties are not of “like class” so long as they are
“like kind.”16 In determining whether exchanged properties are of “like-kind,” no inferences
will be drawn from the fact that the properties are not of “like class.”17 Whether anyone finds this
guidance useful – of even comprehensible – is open to serious doubt.
This far–from-intuitive discussion about the differences between “likekind” and “like class” is further broken down and explained in the Regulations, and is applied to
depreciable tangible personal property by a classification system. The Regulations provide that
there are 13 general asset classes, which classes are based on the asset classes that were
originally defined in Rev. Proc. 87-56, and that are also used to define” Product Classes,” which
in turn are based on the six-digit Product Classes defined under the North American Industry
Classification System (“NAICS”). These classifications are very complex, detailed, and
ultimately oriented toward he “usual” or “standard” assets used and held in a business context.
The NAISCS, for example, has no classification number for “art” or “oil paintings” or “charcoal
sketches” or “mobiles”.
Some Practical Real World Examples.
The following are some specific examples of types of property where there has been an explicit
legal determination as to whether the property in question is “like kind” or not “like kind”:
The exchange of a truck used in a business for a new truck to be used in
the business is like kind. [Reg. §1.1031(a)-1(c)].
A an exchange of a major league baseball contract for a major league
baseball contract is a like-kind exchange. Rev. Rul. 67-380, 1967-2 C. B. 291. This is true even
if you trade a young Lou Brock for an aging Ernie Broglio (a famously bad trade by the Chicago
Cubs), or if trade Heathcliff Slocum for Derke Lowe and Jason Veritek (a famously good trade
by the Boston Red Sox).
An exchange of a football contract for a football contract. Rev. Rul. 71123 and Rev. Rul. 71-137.
An exchange of Chamber of Commerce memberships. C. C. Wyman and
Company v. Commissioner, 8 BTA 408 (1927).
An exchange of steer calves for registered Aberdeen angus livestock,
Wylie v. U.S. 281 F. Supp. 180 (Northern District of Texas, 1968).
Exchanges of non-currency bullion type coins of one country for noncurrency bullion type coins of a second country. Rev. Rul. 76-214. [This means that you can
trade Canadian Maple Leafs (one oz. coin) for a South African Kruggerrand.]
See Reg. Section 1.1031-2(a).
Reg. Section 1.1031-2(a).
Reg. Section 1.1031-2(a).
On the other hand, numismatic coins held for investment are not like-kind
with bullion coins held for investment. Rev. Rul. 79-143.
Gold bullion held for investment is not like-kind with silver bullion held
for investment. Rev. Rul. 82-166. [The IRS ruled that “silver and gold are intrinsically different
metals and primarily are used in different ways.”]
The IRS ruled that passenger vans and sports utility vehicles are of like
kind to cars. See PLR 200450005 and 200240049. It was held the difference between
automobile and SUV does not rise to the level of a difference in nature or character.
On the other hand, the IRS ruled that a light duty truck is not of a like kind
to a car because the vehicles differed in nature or character. See PLR 200240049.
Livestock of different sexes is specifically defined to be not of “like kind”
for purposes of 1031. Code §1031 (e). See Reg. §1.1031(e)-1.
However, 12 half-blood heifers and 12 three-quarter-blood heifers bred by
artificial insemination. The half-blood heifers were held to be of like kind. Rutherford v
Commissioner, TC Memo 1978-505. NOTE: The Rutherford case also stands for the interesting
proposition that a transaction could qualify as a 1031 exchange even though the property being
received (in that case, the three-quarter-blood heifers) did not exist at the time the transaction
was initiated. This would suggest that art might arguably be exchanged for delivery of a piece of
art that has not yet been created at the time of the outbound transaction.
What does “Like Kind” Mean in the Art World?
The Internal Revenue Service does not like art. Perhaps somewhere, deep
within the bowels of the IRS headquarters building in Washington DC, surfeited in bureaucracy
and despair, there sits a person who secretly cherishes the sophistication of a Matisse, who revels
in the quiet enjoyment of a Monet. But the IRS itself has almost nothing to say about art – good
or bad. In fact, the IRS is on record, in a 1992 Field Service Advice, as stating that they will not
rule on the issue of whether art work is “like kind” with other art unless “forced to do so on
In point of fact, the IRS has been almost entirely mum of the subject of the
“like-kindness” of works of art. The closest thing we have to authority on this point is PLR
8127089, in which the IRS addressed a somewhat similar (but not identical) Code provision,
Code §1033, that deals with the tax-free replacement of property that has been lost, stolen,
destroyed or damaged. In that ruling, the property in question was lithographs, and the legal
standard applicable under Code §1033 was whether the property acquired as replacement
property from the destroyed lithographs was “related or similar in purpose or use,” which
standard is most definitely a narrower and difficult standard than the “like kind” requirement
under Code §1031.
Applying the Code §1033 standard, the IRS ruled that lithographs could
by replaced by other lithographs, but could not be replaced by art work rendered in “other artistic
media”, such as oil paintings or water colors, sculptures or other graphic forms of art.
PLR 8127089 Explored in Greater Detail.
In PLR 8127089, the taxpayers sought a private ruling from the IRS on
whether property qualified as “similar or related in purpose or use” under Code Section 1033.
The ruling request arose after a fire occurred in the residence then
occupied by the taxpayers. There was damage to an art collection consisting of approximately
3,000 lithographs, representing the works of approximately 200 different artists and having
substantial value. The art collection damage also included some oil paintings, pencil drawings,
sculptures, masks, wood carvings and block prints. There was smoke and water damage to this
collection. Insurance proceeds were paid to the taxpayers in the amount of the damage. The
bulk of the insurance proceeds were paid for the damage to and loss in value of the print
collection; 1 percent or less was attributable to the loss in value of art objects other than the
lithographs. Some portion of the insurance proceeds represented gain.
The taxpayers were experiencing difficulty in having the lithographs
restored within a reasonable period of time. They proposed instead to buy other works of art. The
proceeds would be used to purchase replacement property which would consist of approximately
63 percent lithographs and 37 percent art works in other artistic media, such as oil paintings,
watercolors, sculptures or other graphic forms of art.
Under the provisions of section 1033(a) of the Code, when property is
involuntarily converted into money, the taxpayer must purchase property similar or related in
service or use to the property converted in order to avoid recognizing gain.
IRS Ruling. In 8127089, the IRS ruled as follows:
“The facts presented have established that you are proposing to replace approximately 99
percent of the lithographs and approximately 1 percent of art works in other artistic media
that were partially destroyed with approximately 63 percent lithographs and 37 percent
art works in other artistic media. The Internal Revenue Service will not consider as
property similar or related in service or use, art work in one medium, destroyed in whole
or in part, replaced with art work in another medium. Therefore, in order to qualify for
complete non-recognition of gain under section 1033(a) you must purchase the same
percentage of lithographs as were destroyed in whole or in part and the same percentage
of art works in other artistic media as were destroyed in whole or in part.
“Accordingly, gain will be recognized under section 1033(a) of the Code if proceeds of
insurance derived from the partial destruction of approximately 99 percent lithographs
and approximately 1 percent art works in other art media are reinvested in approximately
63 percent lithographs and approximately 37 percent art works in other art media. Gain
would be recognized to the extent that 36 percent of the proceeds were reinvested in art
works in other artistic media.”
JBD3 Commentary on Like-kindness of Various Mediums of Art.
For the reasons already described above, the IRS has been very reticent to
provide helpful guidance to taxpayers on what factors or criteria should be applied to determine
the like-kind characteristics of art.
Instead, one must divine the answers by contemplating tea leaves and
various tangential and indirect guidance, such as PLR 8127089.
It should be noted that PLR 8127089 dealt with Code §1033, which is
inherently a more narrow and specific standard than the “like kind” standard under Code §1031.
Even under the more narrow standards of Code §1033, the IRS ruled (albeit in a private letter
that no one except the recipient can rely on) that proceeds of insurance from destroyed
lithographs (99% of the total insurance proceeds) could be reinvested in lithographs, and that
insurance proceeds from the 1% of art works rendered in “other art media” could be reinvested in
“other art media.” It was held that the 36% of the insurance proceeds attributable to lithographs
that were reinvested in “other artistic media” would result in gain recognition (i.e., a deemed
taxable exchange of 36% of the destroyed lithographs for 36% of the insurance proceeds).
Based almost entirely on this one relatively tangential private letter ruling
under Code Section 1033, tax advisors generally feel comfortable concluding that artwork in the
same medium will be considered to meet the like-kind standard of Code Section 1031, while
artwork rendered in different mediums raises significant concerns. For example, it has been
suggested that the following are possible guidelines for a “like kind” exchange of art work:
Lithograph for lithograph.
Oil painting for oil painting.
Water color for water color.
Sculpture for sculpture.
Stamp for stamp.
Coins with numismatic value for coins with numismatic value.
A violin exchange for a violin, (and possibly for other musical
instruments, where the exchanged property under the same NAICS Code).
Rare or vintage wine exchanged for rare or vintage wine (or
possibly exchanged for another alcoholic beverage).
A diamond exchanged for a diamond (or possibly for another
precious gem).
An antique exchanged for an antique (the term “antique” covers a
HUGELY broad definition of “class,” so who knows if that broad definition would withstand
IRS challenge).
Further Possible Examples of Like-Kind Comparisons in Art.
See Exhibit A at the back of this Outlinefor a fun quiz on whether you can recognize kindness
when you see it.
An interesting and very complicated topic is whether a sale or exchange of
tangible personal property, including specifically a work of art, is subject to the sales/use tax in
one (or more) jurisdictions. The District of Columbia and 4518 out of the 50 U.S. states impose
some sort of sales and/or use tax on purchases of tangible property, so a sales/use tax can be a
considerable (and expensive) factor in a sale of highly valuable art.
State sales and use tax rules are particularly difficult to summarize
because the rules is different -- and often dramatically different -- in each state jurisdiction, and
so very few general or global observations can be made about even the most basis or “vanilla” of
transactions. For purposes of this booklet we will examine below the applicability of
Massachusetts sales/use tax law, M.G.L. c. 64H and 64I (herein the “Mass Sales Tax”) to a sale
or exchange of art under various factual scenarios. We will also, from time to time, discuss
certain aspects of the sales and use tax laws of other states, but specific reference to that state.
Again, this discussion is not tax advice with respect to your particular transaction, and you
should seek counsel from your tax advisors based on the specific facts and circumstances in
your situation.
Basic Massachusetts Sales and Use Tax Rules.
The Massachusetts sales tax is set forth in Chapter 64H of the
Massachusetts General Laws. The sales tax is imposed upon "sales at retail in the commonwealth
by any vendor, of tangible personal property or of [certain] services performed in the
commonwealth ..." M.G.L. c.64H, §2.
The Massachusetts use tax, complementing the sales tax, is set forth in c.
641 of the Massachusetts General Laws. The use tax is imposed upon "the storage, use or other
consumption in the Commonwealth of tangible personal property or services purchased from any
vendor for consumption within the Commonwealth."
The Massachusetts Sales Tax and Use Tax are imposed at a rate of 6.25%
on the purchase price.
A person who uses tangible property in Massachusetts can claim a credit
for Sales Tax or Use Tax previously paid to another jurisdiction in connection with the purchase
of the relevant property.
The states that charge no sales or use tax include Alaska, Delaware, Montana, New Hampshire, and
Nevada. See section _____ for a brief further summary about the sales and use tax laws in these five states.
Casual and Isolated Sale Exception.
The “casual and isolated sale” exception under the Mass Sales Tax is
found at Chapter 64 H, section 6 (c), which state as follows:
“Casual and isolated sales by a vendor who is not regularly engaged in the
business of making sales at retail; provided, however, that nothing contained in
this paragraph shall be construed to exempt any such sale of a motor vehicle ...”
In general, a sale of art by an individual collector to another individual
collector will likely qualify for this exemption from the sales and use tax. However, be aware
that sales by auction houses or galleries are not considered casual or isolated sales, and so a sale
of art through an auctioneer is usually a taxable sale and the auctioneer is expected to collect and
pay over the state sales tax in the state of sale. This is certainly the case in Massachusetts.
Identifying the Jurisdiction in which the “Sale” Occurs.
A fundamental issue in sales and use tax planning for an exchange of art is
identifying the jurisdiction(s) in which the “sale” of each piece of art is going to occur (both the
sale of the “relinquished” art and the purchase of the “replacement” art), and then the
jurisdiction(s) in which “use” will occur after the exchange.
The way the sales and use tax works is that the state where the transaction
takes place has the first right to impose a sales tax on the transaction. “Where” a sale occurs can
be a complicated and nuanced discussion, because it is possible to control where the transfer of
title occurs (e.g., title can be transferred at the seller’s address, or it can be transferred on
delivery to the buyer’s address in a different state) and so one can structure a sale to occur in a
jurisdiction where there is low sales tax, including in one of the five states with no sales tax,
(these five are New Hampshire, Delaware, Montana, Oregon and Alaska, in order of their
proximity to Massachusetts).
However, even though it is relatively easy to avoid the sales tax, this
merely raises the specter of a use tax, which is a complementary tax to the sales tax that applies
to the purchase and use of property in cases where a sales tax has not yet been paid to another
jurisdiction (or in cases where a lesser sales tax amount has been paid than the sales/use tax
amount that would be assessed in the state where the subsequent use occurs)
To do effective sales/use tax planning, one must not only purchase the
painting and sell the painting in a jurisdiction that has either zero sales tax or lower sales tax (that
is relatively easy to do, particularly with a highly mobile property such as an airplane or a work
of art), but the subsequent “use” must be permanently located in the lower tax jurisdiction, or the
result could be a use tax that negates the benefit of securing a lower sales tax.
A recent New York Times article written by reporter Graham Bowley
noted that purchasers of art who reside in California often purchase art and arrange to have it
delivered directly to an art museum in Oregon (the closest “no sales tax” state to California)
where title transfers (and thus no sales tax is due) and where there is no use tax either. [NOTE:
The sales tax and use tax rate are almost always imposed at exactly the same rate in every state,
precisely because the use tax is a “backstop” to the sales tax and not a separate, independent tax.
Therefore, in Massachusetts, the sales tax is 6.25% and the use tax is 6.25%. However, the
sales/use tax rates differ, often dramatically, from state to state.]
California has a relatively unusual provision in its sales and use tax
statute, which is that when property purchased and used for the first 90 days outside of
California, it is conclusive evidence that the property was purchase for use outside of California,
and therefore no use tax will be assessed if the property is then brought into California after that
90-day period. [The same rule applies to other property, e.g., boats.]
The CA use tax statute reads in relevant part as follows:
(3) PURCHASE FOR USE IN THIS STATE. Property delivered outside of California to a
purchaser known by the retailer to be a resident of California is regarded as having been
purchased for use in this state unless a statement in writing, signed by the purchaser or the
purchaser's authorized representative, that the property was purchased for use at a designated
point or points outside this state is retained by the vendor.
Notwithstanding the filing of such a statement, property purchased outside of California which is
brought into California is regarded as having been purchased for use in this state if the first
functional use of the property is in California. For purposes of this regulation, "functional use"
means use for the purposes for which the property was designed. Except as provided in
subdivision (b)(5) of this regulation, when property is first functionally used outside of California,
the property will nevertheless be presumed to have been purchased for use in this state if it is
brought into California within 90 days after its purchase, unless the property is used, stored, or
both used and stored outside of California one-half or more of the time during the six-month
period immediately following its entry into this state. Except as provided in subdivision (b)(5) of
this regulation, prior out-of-state use not exceeding 90 days from the date of purchase to the date
of entry into California is of a temporary nature and is not proof of an intent that the property was
purchased for use elsewhere. Except as provided in subdivision (b)(5) of this regulation, prior outof-state use in excess of 90 days from the date of purchase to the date of entry into California,
exclusive of any time of shipment to California, or time of storage for shipment to California, will
be accepted as proof of an intent that the property was not purchased for use in
California.[Emphasis added]
JBD3 OBSERVATION: It is likely that the Massachusetts DOR would
not feel constrained in the least from going after an art collector who brings in a painting more
than six months after purchase (without having paid a sales/use tax in any other state). Both
states have presumptions based on when you first bring the property into the state. But the
presumptions are significantly different. Massachusetts says: “It shall be presumed that tangible
personal property shipped or brought to the commonwealth by the purchaser was purchased from
a retailer for [use] in the commonwealth, provided that such property was shipped or brought
into the commonwealth within six months after its purchase.” The presumption, or lack thereof,
regarding Massachusetts use is not dispositive for either side.
The Town Fair Tires case in Massachusetts makes it reasonably clear that
any use tax exposure will not be the seller/art dealer’s problem, but the buyer should not assume
that Massachusetts will accept or feel bound by the (implied but not actually stated) reverse
presumption. In both Massachusetts and California, the question is whether the art was
purchased “for use” in the state.
Although to to the author’s knowledge it has rarely been raised to date, an
art work that is purchased in a low tax jurisdiction (e.g., New Hampshire) and owned by a person
residing in a low tax jurisdiction (again, possibly New Hampshire) could conceivably be subject
to “use” tax if the work of art were lent for a long period of time to a museum in a jurisdiction
that imposes a use tax, e.g., to the Museum of Fine Arts in Boston, Massachusetts! Again, to the
author’s knowledge, the Massachusetts Department of Revenue, which is often very aggressive
in its interpretation and enforcement of the tax laws, has never attempted to assert a use tax on
works of art lent to Massachusetts museums. However, if you look at the headlines about
government finances you can draw your conclusions about whether the government is looking
for ever broader sources of revenue!
By the way, on the relinquished leg of an exchange transaction, this
transaction will typically be a “sale” for sales/use tax purposes, and the buyer will have sales tax
liability, but the tax collection obligation may or may not be imposed on the seller. For example,
a seller selling art to a buyer in Massachusetts may well qualify for a “casual or isolated” sale
exemption. On the other hand, the buyer of the property will typically owe a sales tax liability
to the jurisdiction where the sale occurs, and then can have potential use tax liability in a
subsequent jurisdiction where the property is held and used, unless the sales tax in the state of
sale is paid and equals or exceeds the use tax imposed by the subsequent state of use.
Example: Collector Y exchanges art in like-kind of exchange with
Collector Z, each of them exchanging paintings worth $10 million in a transaction that qualifies
as a like-kind exchange and thus eligible for non-recognition of gain under Code Section 1031.
The Work Y transferred by Collector Y is subject to sales tax (and possibly a later use tax) owed
by Collector Z, and Work Z transferred by Collector Z to Collector Y is subject to sales tax (and
possibly a later use tax) owed by Collector Y. If the transaction occurs in the state of Delaware
or the state of New Hampshire, no sales tax is owed by either party in the sale. However, if they
each then take the property to the place where they each intend to “use” it, and the use tax will
apply. For example, if the exchange takes place in New Hampshire, and if Collector Y resides in
Massachusetts and brings Work Z into Massachusetts within six months following the exchange,
there will be a 6.25% use tax imposed, and, since no sales tax was paid in New Hampshire, and
therefore the full 6.25% MA use tax will be owed on the full purchase price of the art sale.
Trade-In Rules (Generally Limited to Airplanes and Vehicles).
Under Massachusetts law, it is possible to minimize sales and use tax
liabilities with respect to certain types of property by arranging, to the extent feasible, a like-kind
exchange to comply with provisions that provide a sales and use tax credit for “trade ins.”
M.G.L. c. 64H, §§ 26 and 27A provide, respectively, for trade-in transactions (which for all
intents are purposes are “exchanges”) involving motor vehicles or trailers (§26) and involving
boats and airplanes (§27A).
Section 26 provides that where “a trade-in of a motor vehicle or trailer is
received by a dealer in such vehicles holding a valid vendor’s registration, upon the sale of
another motor vehicle or trailer to a consumer or user, the tax [i.e., Massachusetts Sales Tax]
shall be imposed only on the difference between the sales price of the motor vehicle or trailer
purchased and the amount allowed on the motor vehicle or trailer traded in on such purchase.”
Similar rules apply to boats and airplanes under § 27A.
NOTE: Many state statutes provide a similar trade-in credit for sales and
use taxes paid where certain property, particularly a motor vehicle or an airplane, is traded in for
a new motor vehicle or new airplane. The sales tax can be quite expense on the purchase of a
$50 million airplane (e.g., 8% New York sales tax would result in a $4 million sales tax
liability). Therefor, in a like-kind exchange of airplanes it is very important to make sure that the
transaction is structured not only to comply with the like-kind exchange provisions of Code
§1031, but also with the trade-in provisions of the applicable state’s sales and use tax law.
The special “trade-in” rules under the Massachusetts Sales Tax are
specific to the types of property noted above, and in particular are not applicable to an exchange
of art for art under the Massachusetts Sales Tax.
In Massachusetts, a typical example of the sales tax issues that need to be
analyzed in a like-kind exchange is described in Letter Ruling 02-10, which involves like-kind
exchange for federal income tax purposes of used motor vehicles for new motor vehicles. The
taxpayer in question purchased motor vehicles for lease, and then eventually sold these vehicles
upon expiration of the lease, and used the proceeds from the sale transactions to purchase
additional replacement vehicles that were also held for lease. This program of vehicle exchanges
was implemented through the use of a qualified intermediary. In that case, it was held that the
taxpayer, i.e., the lessor, did not owe sales tax on the vehicle sales because the sales of the
existing vehicles were exempt (in Massachusetts, the ultimate purchaser pays the sales/use tax
when the car is registered at the Registry of Motor Vehicles) and, on purchases, the lessor was
likewise exempt from sales/use tax because the vehicles were used exclusively for rental until
eventually resold.
JBD3 COMMENT: This ruling is not directly on point for sales of art
work, because it is heavily influenced by the fact that the party in question was a lessor of motor
vehicles, but it illustrates how complicated and nuanced sales and use tax statutes can be in each
respective state.
Use Tax.
The use tax theoretically eliminates any incentive to avoid the sales tax by
making a purchase outside the state.
The use tax is not necessarily a tax imposed on the purchaser. If the
vendor is subject to Massachusetts tax jurisdiction -- that is, if he is "engaged in business in the
Commonwealth" within the meaning of M.G.L. c.64H, §1, he must collect the use tax and it may
be assessed against him.
Only use incident to purchase (or lease or rental) is taxed.
Only use of items "purchased for use in Massachusetts" is taxed. Note the
six-month presumption that property brought in the Commonwealth within six months of
purchase is presumed to be purchased for use in the Commonwealth.
Is there a de minimis level of use that is not taxed? Possibly. See
Minchin v. Commissioner, ATB Docket No. 121890, November 3, 1983.
There is a "credit" for taxes paid to other states.
Taxable use does not include the mere keeping of property in the state
pending use elsewhere. This provision arguably protects a purchaser from assessment even if the
sale took place in Massachusetts.
Exemptions from the sales tax apply to the use tax as well, except for
casual sales of motor vehicles, trailers, boats and airplanes, which are exempt from the sales tax
but subject to the use tax unless the purchaser is a member of the seller's immediate family.
Do you know how to recognize kindness when you see it? Find out by taking the following helpful quiz.
Taxpayer exchanges a copyright on a novel (Gone with the Wind) for a copyright
on a different novel (Fifty Shades of Grey).
Taxpayer exchanges a copyright on a novel (the semi-autobiographical novel To
Sir, With Love by E. R. Braithwaite) for a copyright on a song (To Sir, With Love, sung by Lulu).
Taxpayer exchanges a copyright on a song (Feeling Groovy, by Paul Simon) for
a copyright on a different song (Who Killed Bambi, the title song for the never released film (because it
was too offensive) about the punk rock group the Sex Pistols).
Taxpayer exchanges a tradename and trademark in one business (McDonalds and
its dorky Ronald McDonald) for a tradename and trademark in another business (Burger King and its
dorky king)
Taxpayer exchanges goodwill and going concern value of a business (Durgin
Park Restaurant) for the goodwill and going concern value of another business (Union Oyster House
The Boston Red Sox exchange baseball players Carl Crawford, Adrian Gonzalez,
Josh Beckett plus a bucket of chicken wings for several useless or marginal minor league players.
Taxpayer exchanges an oil painting by Claude Monet (The Luncheon) for an oil
painting by Edouard Manet (Le dejeurne sur l’herbe or Luncheon on the Grass).
Taxpayer exchanges the oil painting Woman in the Bath, painted in 1886, by
Edgar Degas (who by the way despised the term Impressionist) for the Mary Cassatt oil painting The
Child's Bath (The Bath) painted in 1893.
Taxpayer exchanges the most famous oil painting of all time, the Mona Lisa, by
Leonardo Da Vinci, for the most famous sculpture of all time, the David, by Michelangelo.
Taxpayer exchanges a Vincent Van Gogh oil painting for an Alexander Calder
Taxpayer exchange a Rembrandt oil painting used and enjoyed in the United
States for a Rembrandt oil painting to be used and enjoyed in Canada.
The Taxpayer exchanges Andy Warhol’s silk-screen portrait of Marilyn Monroe
for Gilbert Stuart’s oil portrait of George Washington.
Taxpayer exchanges a diamond held for investment for ten small diamonds to be
held for investment.
Taxpayer exchanges a diamond ring for a diamond ring.
Taxpayer exchanges a high quality diamond for a high-quality sapphire.