How is fine art taxed?
Sales of art and collectibles currently are subject to a 28% long-term federal capital gains tax rate—this can be unwelcome surprise for new collectors. This is because top federal tax rates for long-term capital gains from the sale of financial assets is only 20%. In both cases, high-income earners also have to pay a net investment income tax of 3.8%. State taxes also may apply.
There’s precedent for how a change in the tax code can affect art sales. In 2017, U.S. tax reform legislation eliminated so-called like-kind exchanges for personal property, including art, that had allowed those who owned art as an investment asset to sell a work and defer capital gains taxes and associated income taxes if they subsequently bought a similar work.
Although artists, dealers and investors can deduct business expenses related to producing and selling art works, they do pay taxes on the sales of their art. The art sold by artists and dealers is considered inventory, which means sales are taxed generally at rates of up to the highest ordinary income tax rate, which is currently 39.6%. When investors sell there works of art, they are acquiring gains on their investments, like selling stock for a profit. So, those sales are subject to the capital gains tax rate, which is 20% for taxpayers in the highest tax bracket.
The long-term capital gain rate for Fine Art (collectibles), which might apply to both investors and collectors, is 28%. In addition, the Patient Protection and Affordable Care Act of 2010 added a 3.8% surtax on net investment income, which includes Fine Art (collectibles), for certain high income investors and collectors. Therefore, investors and collectors in the highest income tax bracket could pay a tax of up to 31.8% on the sale of collectibles.
In general, artists, dealers and investors can claim any expenses related to creating, acquiring, preserving or transporting art if they are incurred as normal and ordinary business expenses, or if they are incurred in the production of income. While collectors are not able to take these types of deductions, they do get tax benefits when selling or giving away their collections.
Here's how the IRS defines each group:
Artists: This is a straightforward category which describes the people who create works of art. You should know that tax rules are not especially favorable toward artists.
Dealers: This category is intended for people who engage in art dealing (selling art) business. This status is determined by the IRS on an individual basis, in consideration of things like sales activity and intentions upon acquiring a piece of art. For a dealer classification, they must demonstrate that there interest in art is not a hobby, this is because losses and expenses associated with a hobby are never tax deductible.
Investors: Like art dealers, investors must show their interest in art is more than a hobby. To be classified as an investor, an individual must show that art is collected primarily for investment purposes. To determine this the IRS will consider the purpose for which the piece was acquired, the length of time of possession, an investor's other business interests and how the proceeds from the sale of each work is used. To be classified as an investor, an individual must sell, or be willing to sell, a piece of art for profit. The IRS has denied many individuals investor status because they could not document that they ever sold a piece from their collection.
Collectors: Most fine art purchasers will be classified in this category. Collectors are those who appreciate art and accumulate it for personal enjoyment. Expenses for acquiring and maintaining art are not deductible for collectors, favorable tax treatment often can be received when selling or giving collections away.
However, there is still a loophole which is very valuable to those who buy and sell valuable artwork. 1031 exchanges: They work by allowing wealthy art collectors to, and do, save millions in taxes by rolling over the profits from selling their art collection pieces into buying more art. As the price of high-end artwork rises, high end collectors are taking advantage of this opportunity. A §1031 exchange, an art investment fund can diversify, modify, or upgrade a portfolio of artwork into quality suitable for museum loans and other significant exhibitions as the portfolio’s value increases, without recognizing any gain on the sale of the unwanted artworks. When sold artworks are replaced with like-kind artworks, all the capital gains tax that would have ordinarily been incurred upon the sale of the Artwork (asset) will be deferred. The fund can function to restructure the artwork portfolio (collection) to better suit the needs of intended purchaser (collector) at fund termination, such as museums and other collectors, without eroding the value of the portfolio (collection) through capital gains tax. §1031 allows the art investment fund to exchange out of (sell off) artwork that has plateaued appreciation, into pieces with a greater upside potential, for the purpose of preserving and maximizing the profitability of the art fund (collection) without paying or incurring capital gains tax on the sale of those no longer appreciating Artworks (assets).
Instead of paying taxes on their proceeds, collectors can turn around and put the money towards adding to their collection.