So, your client is one of the lucky few who find that they own a one-of-a-kind gemstone, jewelry, or other tangible property worth hundreds of thousands of dollars. Sell it? That involves significant taxes – 28% federal capital gains taxes (scheduled to rise to 31.8% as of 2013) for property held for more than one year, as well as state capital gains and transfer taxes. The tax-deferred alternative to outright sale of artwork is to make a like-kind exchange of the artwork.
Most investors think of 1031 exchanges as a means of deferring capital gains taxes on their real estate investments, but “like-kind” exchanges apply to any investment assets, including investments in artwork, gemstones, numismatics, and other tangible assets. Personal Property like-kind exchanges are handled somewhat differently than real estate exchanges, and you will need to have access to a Qualified Intermediary that has experience in these types of exchanges, but it is not excessively complicated or costly.
Gemstones and 1031 Exchanges: a Practical Guide
In general, gemstones can be exchanged, and the gains deferred, in a similar fashion to real estate or other investment properties. With a client selling artwork or other collectibles, the issue of whether to use a like-kind exchange breaks down into two questions:
Is there a taxable gain?
Gains on long-held collectibles are taxable under IRC Sections 1(h)(5)(A) and 1001 at maximum federal tax rates of 28%, and state and local income taxes also may apply. Worse yet, many collectors have not retained adequate proof of their cost basis for every collectible. See, e.g., Fisher, TC Memo 1986-141, where the Tax Court upheld the Service’s disallowance of the loss claimed by the taxpayer on the disposition of a stamp collection begun in his youth. The taxpayer failed to establish the collection’s basis, not having maintained records of his stamp purchases.
For my client to avoid recognizing a gain on the sale of a collectible, under IRC Section 1001, the transaction requirements are 1) the item is held for productive use in a trade or business or for investment and 2) is exchanged solely for property of a like-kind to be held either for productive use in trade or business or for investment. See IRC Section 1031(a)(1). Certain property is excluded from nonrecognition treatment, pursuant to IRC Section 1031(a)(2), including stock in trade or other property held primarily for sale. Gemstones and other collectibles generally are not “excluded property” under IRC Section 1031(a)(2), unless they are inventory, so there should be no issues.
Usually, this requires that we spend some time with the client inventorying, aggregating and sorting their collection so that we can readily identify which are investments, which are a hobby, and which are decorative. Without this groundwork, it can be difficult to prove that the artwork is, indeed, an investment.
Is there a like-kind exchange?
The second tax-related issue is whether the exchange is one of “like-kind.” As used in IRC Section 1031(a), “like-kind” has reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class, according to Reg. 1.1031(a)-1(b). Personal property held for investment includes assets such as stamps, gems, antiques, or coins. (There are limitations, however – bullion-type coins and numismatic-type coins are not of like-kind, see Rev. Ruls. 79-143, 1979-1 CB 264, and 82-96, 1982-1 CB 113.) A gemstone exchanged for a number of other gemstones by my client would constitute like-kind property, but the replacement gemstones do not have to be of the same type (i.e., a faceted Tanzanite for rough emeralds) as the grade or quality of the gemstones does not matter, though its nature (gemstones) and character (investment) does. My client cannot, however, exchange a gemstone for an oil painting.
To be continued…
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