Art and Collectibles Survive Recent Congressional Scrutiny of Section 1031 Exchanges

The Jobs and Growth Tax Relief Reconciliation Act of 2003 temporarily reduced the top rate on long-term capital gains from 20 to 15 percent, the lowest rate in six decades. The recent fight over tax reconciliation centered on whether automatic reversion to old rates should be allowed to occur or should be postponed. With narrow Senate approval on a nearly party line vote of 54-to-44, those tax hikes were delayed for two years with the signing by President Bush of H.R. 4297, the Tax Increase Prevention and Reconciliation Act of 2005 (May 11, 2006).

The extension of the 15 percent rate through 2010 has not been without its detractors. During the Senate's February 1, 2006 consideration of the House Bill, Senator Conrad stated:

It took 42 Presidents 224 years to run up $1 trillion of debt held abroad...In the last 5 years..., we have doubled that amount-in fact, more than doubled that amount. That is an utterly unsustainable course. It is absolutely incumbent on us to get hold o four budget deficits and our trade deficits that are-requiring this unprecedented foreign borrowing.

In Senator Schumer's statement at the February 2, 2006 Senate Finance Committee Hearing on the FY 2007 Budget, he passionately argued against passage of the House Bill:

Look at what this budget contains...Nearly two trillion dollars in additional tax cuts, most of it geared towards the well-to-do, rather than the middle class that's finding it harder and harder to make ends meet with rising health care, tuition, and energy costs.

With increasing sentiment along these lines, some lawmakers are advocating limitations to the kinds of assets applicable for tax deferral. Senate Finance Committee Chair Charles Grassley was quoted in January 2006 as stating that, while Section 1031 has a "philosophically sound basis," the Committee might "tinker" with the law.

What is Under Attack

One target in the cross-hairs is the use of Section 1031 to defer tax on appreciation of art and collectibles, otherwise taxable at a rate of 28 percent. See "Bartering to Avoid Taxes," Wall Street Journal (12-29-05). With alleged increasing use of Section 1031 for such items as a famous baseball bat or rare stamps, some lawmakers are carefully considering whether its use tends toward the abusive.1 The argument here is that only the wealthy can afford to purchase such items and are, therefore, uniquely positioned to pay tax on any appreciation in value. The Wall Street Journal author reflects this general assumption by stating that use of Section 1031 for collectibles constitutes "bartering for the well-to-do." However, 'collectibles' may form a considerable portion of some investors­ total net worth, so the criticism seems a bit harsh.2 One of the leading proponents in favor of revised capital gains treatment of art went on record in 2003 as stating that: "Collecting isn't just for the hoity toity." In our view, much of the outcry is based on anecdotal evidence, some rising to the level of urban legendary status. The Congressional Budget Office has been criticized by many for its "dreadful forecasting record" in putting the numbers to paper, so to speak, having recently admitted that it under-estimated capital gains revenues by $87 Billion. See Wall Street Journal Online Op Ed (March 2, 2006). Besides, any sustained attack of this sort would suggest confusion among Congressional tax hawks.

Congress­ Rich and Inconsistent Efforts to Grapple with 1031 Treatment of Art and Collectibles

Before 1969, artists could donate self-generated works to a non-profit institution and receive a fair-market value deduction against income. Subsequent to 1969, as part of broad tax reform and the creation of the Alternative Minimum Tax, Congress changed the law to allow only a deduction equal to the cost of raw materials. As a result, artists typically did not donate their own works during their lifetime and, instead, bequeathed works posthumously through their estates. In 1986, Congress passed sweeping tax reform and created debilitating consequences for donors of art and collectibles by (1) eliminating a deduction of appreciated property equal to fair-market value and (2) imposing the Alternative Minimum Tax to deductible donations. Congress did not wait long to act again, however.

First, the 1993 Budget Reconciliation Act reinstated tax deductions for qualifying gifts at fair-market value. Congress eliminated the treatment of contributions of appreciated property as a tax preference for AMT purposes. Thus, if a taxpayer makes a gift to charity of property (other than short-term gain, inventory, or other ordinary income property, or gifts to private foundations) that is real property, intangible property, or tangible personal property the use of which is related to the recipient tax-exempt purpose, the taxpayer is allowed to claim the same fair-market-value deduction for both regular tax and AMT purposes (subject to present-law percentage limitations). Second, the 1999 Taxpayer Relief Act eliminated application of the AMT to deductible gifts. Retroactive to June 1992, the revised AMT rules permit donations of the appreciated value of art and collectibles at present market value and allow the gain to offset income, subject to certain deduction limitations and tight restraints, without incurring a capital gains tax. The definition of qualifying gifts has been expanded to include not only gifts of personal property like books and paintings, but also intangible property such as royalty rights, stock gifts to colleges, and real property to nature conservancies. Finally Congress considered legislation to again encourage investments in art and collectibles when it considered passage of The Art and Collectibles Capital Gains Tax Treatment Parity Act of 2005 (S. 1186 & H.R. 1120).

The 2005 Parity Act is a rough combination of two similar bills introduced as far back as 2001: The Art and Collectibles Capital Gains Tax Treatment Parity Act (H.R. 1598) and the Artist-Museum Partnership Act (S. 694). This new bill addresses two internal inconsistencies in the Internal Revenue Code by:

1. Lowering the capital gains tax rate for investments in art and collectibles (28%) so they would be the same as an investment in stocks and bonds (15%).
2. Giving artists a deduction equal to fair market value subject to the work being created at least 18 months prior to the donation and a professional appraisal.

Senator Schumer's press release on the subject quotes him as stating:

In a bi-partisan way, we can make sure the tax code is as fair towards investors in stocks and bonds as it is for investors in arts and other collectibles.

Clearly, the policy position expressed in the 2005 Parity Act is to encourage artists to donate their works in their lifetime to further the public interest in art of significant value. Congress had already addressed in 1993 and 1999 the conundrum forced upon patrons of the arts who donated their works to libraries, museums and such, so it was now the artists' turn. However, lawmakers' negotiations resulted in another legislative attempt to make permanent equal treatment of art and collectibles to that afforded stocks and bonds. Unfortunately for some, Congress failed to enact the 2005 Parity Act, and the debate over 1031 treatment of art and collectibles has subsided, at least for now.

Conclusion

The battle over tweaking the tax-deferral system to make art and collectibles stand on equal footing with stocks and bonds appears on hold with passage of the 2005 Reconciliation Act and failure of the 2005 Parity Act. The next round of negotiations on making permanent other tax reductions of the Bush Administration have already begun with lawmakers' wrangling over the proposed changes to the estate tax laws. Given its rich history, we can be assured that lawmakers will revisit the capital gains issues surrounding art and collectibles sooner than later.