The Tax Benefits of Turning Art into Real Property

Proposed regulations could help developments financially as well as aesthetically.

A 14-foot steel sculpture of a red balloon rabbit adorns the lobby of 51 Astor, a Class A office building in Manhattan developed and owned by Edward J. Minskoff Equities. The piece’s value may be difficult to appraise, but any estimate would probably be substantial: In 2019, a three-foot steel bunny by the same artist, Jeff Koons, sold for more than $91 million.

Bringing an impressive piece of art into the lobby can elevate the status of a property and serve as a welcome amenity for tenants. But  significant tax benefits can flow from incorporating art into real estate projects.

Under the 2017 Tax Cuts and Jobs Act (TCJA), assets such as airplanes, ships and art can no longer benefit from like-kind tax-deferred exchanges provided for in Section 1031 of the Internal Revenue Code. Like-kind exchanges allow property owners to avoid triggering a taxable gain when selling property as long as they purchase property of a similar type during the same time period.

Before Congress changed the law, investors selling pieces of art at a gain could purchase other pieces and enjoy Section 1031 benefits in the same way that real estate investors do. The TCJA, however, limited Section 1031 benefits to real estate. Investors in a variety of industries, including the art world, lost this tax benefit.

But while Section 1031 is now limited to real property exchanges, the definition of real property eligible for Section 1031’s benefits is not clear in the tax code. In contrast, Treasury Regulation Section 1.856-10(a), interpreting the section which defines real estate investment trusts (REITs), includes a definition of real property: “inherently permanent structures” (e.g., permanently affixed cell towers, fences or railroad tracks) and “structural components of inherently permanent structures” (e.g., fire escapes, doors and chimneys if integrated into the inherently permanent structure and owned together with that structure).

The REIT regulations cite a sculpture as an example of something that qualifies as an inherently permanent structure and, therefore, as real property. In that example, an office building atrium is described with a sculpture that  “measures 30 feet tall by 18 feet wide and weighs five tons. The building was specifically designed to support the sculpture, which is permanently affixed to the building by supports embedded in the building’s foundation. The sculpture was constructed within the building. Removal would be costly and time consuming and would destroy the sculpture.”

The REIT regulations include a test to determine whether assets not specifically listed in the rules are considered to be real estate, and the sculpture example is analyzed in the regulations using that rule.

Until recently, however, Section 1031 investors did not have clear guidance about which assets purchased or sold with a building sale would qualify for the tax-deferred exchange. Wrongly assuming that certain assets constitute real estate could result in an exchange that might be challenged by the IRS in whole or in part. And assuming that certain assets could not be included within the exchange, selling them in a simultaneous transaction that did not benefit from tax-deferral benefits could cause investors to trigger gains unnecessarily or to pursue a less beneficial course of action.

In response, the IRS issued proposed regulations in June that were taken in large part from the REIT regulations. As in the REIT rules, the proposed Section 1031 regulations provide examples of “inherently permanent structures” and “structural components of inherently permanent structures” and provide a test for determining whether an asset is an inherently permanent structure that qualifies as real property for Section 1031 purposes. The determination is based on the following five factors: “(1) The manner in which the distinct asset is affixed to real property; (2) Whether the distinct asset is designed to be removed or to remain in place; (3) The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed; (4) Any circumstances that suggest the expected period of affixation is not indefinite; and (5) The time and expense required to move the distinct asset.”

The proposed regulations even include an example involving a statute that is almost copied word-for-word from the REIT regulations. All five factors clearly support the sculpture as an inherently permanent structure, and the proposed regulations make clear that the sculpture would be real property. In certain cases, this can mean a valuable tax deferral for developers  despite the 2017 changes to Section 1031. But the IRS’s proposed treatment of art as real estate is solely for the purpose of the like-kind exchange tax provisions. Tax benefits such as depreciation deductions, which are generally not available for art assets, will not become accessible to art owners as a result of the proposed regulations.

In the new proposed regulations, the IRS made clear that taxpayers may rely on the proposed regulations pending the enactment of final regulations. As a result, developers might consider making art an important part of current and future project plans. There will be a wide array of possibilities for incorporating art into real property in a way that qualifies the pieces as inherently permanent structures.

For example, the regulations provide that “affixation to real property may be accomplished by weight alone.” Yet the new rules, and the five-part test presented by the IRS, require qualifying art to be permanently affixed, a feature that may involve planning by designers, architects and developers. 

Daniel Pessar is a student at Harvard Law School. Before law school, he worked in real estate private equity for six years.