A New Tax Benefit for Art Collectors
The Tax Cuts and Jobs Act signed into law in the USA in late December 2017 created a new tax benefit that is particularly beneficial to the country’s art-collecting taxpayers. This benefit comes from a program in which investors receive varying levels of special tax treatment if they invest capital gains into qualified Opportunity Zone Funds (OZFs) designed to spur economic activity in economically distressed communities. The longer investors keep their investments in OZFs, the greater the tax benefits they receive.
How Opportunity Zone Investments Work
Opportunity Zones (OZs) are economically distressed communities where new investments that meet certain criteria are now eligible for preferential tax treatment. By December 2018, nearly 9,000 communities across the country had been certified as OZs. They exist in every state and major city and include numerous suburban and rural locations. Some OZs are also located near established communities and transportation hubs. In New York City, for example, 306 census tracks (the unit of designation in the OZ process) have been classified as OZs: Manhattan has 36, with most in the northern half of the island; Brooklyn has 125 including parts of Williamsburg, Bushwick, and the entire Brooklyn Navy Yard; the Bronx has 75; Queens has 62; and Staten Island brings up the rear with 8. Approximately 1.2 million people live in these designated areas.
The cornerstone of the OZ program is the OZF, a new type of investment vehicle. Taxpayers who sell appreciated assets such as fine art, real estate, or stocks, can receive three special tax benefits if they roll their gains into an OZF within 180 days. First, they can defer federal taxes on these gains until 31 December 2026, or until they sell their OZF investment — whichever is earlier. This enables investors to put more capital to work for a longer period. Second, if they hold the fund for at least five years prior to 31 December 2026 they can reduce their deferred gain subject to federal taxation by 10%, which will lower the ultimate tax they paid on that gain. If they hold the investment for two more years, the tax liability is reduced by an additional 5% for a total reduction of 15%. Third, they can eliminate federal taxes due on OZF profits if they hold the investment for at least 10 years.
OZF tax benefits are only available to taxpayers who fund their investments with capital gains from asset sales. While taxpayers can elect to invest more cash into an OZF, the tax benefits are limited to the portion of their investments funded with capital gains from asset sales. As a result, the OZ program is an attempt to use tax incentives to reallocate capital in the economy away from existing assets and into new investments in low-income communities. It is a way to bring private sector dollars into distressed communities, many of which have been passed over since the 2008 financial crisis. The five-, seven-, and ten-year tax-incentive triggers are designed to help keep the money in these communities for the long haul.
To be an eligible investment, an OZF must acquire equity interests in a business, business assets, or a real estate project located in a qualified OZ. Loans are not eligible for the special tax incentives. Real estate investments are also subject to a substantial rehabilitation requirement, so a fund cannot simply buy and hold existing OZ real estate assets. They either need to be new real estate projects or, in the case of an existing real estate asset, they must make improvements in the property equal to the value of their initial investment. Some eligible OZF investments include growth capital for mid-sized companies located in OZs, equity capital to convert an under-used warehouse into a mixed-use development, and funds to develop and lease new affordable housing.
Art-Related Capital Gains to Fund OZ Investments
Because the federal capital gains tax on art and collectables is 28%, higher than the 15% or 20% rate for financial investments, gains from the sale of fine art are a particularly tax-efficient way to invest in OZFs. Let us walk through a hypothetical example of how these benefits work with art-related capital gains.
Suppose a taxpayer sells several artworks during the early 2019 auction season, resulting in USD 10 million in long-term capital gains. They then invest these gains into an OZF within 180 days. For the purpose of this example, they make their investment in July of the same year, after receiving sale proceeds from the auction house. At the current 28% federal capital gains rate for art and collectables, the new law enables the taxpayer to defer, for now, USD 2.8 million, which would otherwise be remitted to the Internal Revenue Service. In addition, because of the way the Medicare surtax on net investment income is calculated, the taxpayer may also be able to defer this 3.8% tax. As a result, the taxpayer retains an additional USD 380,000 for a total federal tax deferral of USD 3,180,000. Depending on the state in which they live, the taxpayer may have to pay state-based capital gains taxes in tax year 2019 on the USD 10 million gain; the OZ tax deferral applies at the federal level only. The value of the federal tax deferral to the taxpayer depends on two things: the length of time they hold the OZF and the rate of return they earn on the deferral amount. Some hypothetical calculations on the value of this deferral are shared at the end of this section.
Continuing with the example, at the five-year anniversary of the investment in the OZF (which would be in July 2024), the taxpayer is eligible to reduce the value of their deferred capital gain by 10%, or USD 1 million. After seven years, or in July 2026, they can reduce it by another 5%. If the taxpayer then sold their OZ investment, they would pay federal taxes on a USD 8.5 million gain rather than on the original USD 10 million. That is a saving of USD 477,000 for holding the investment for seven years based on the 28% federal capital gains tax rate (on art) and the Medicare surtax rate of 3.8%. If they continue holding their OZ investment, the taxpayer will need to pay capital gains taxes on the USD 8.5 million gain when the deferral period ends on 31 December 2026. But taxpayers will likely elect to finance this tax payment with debt or take advantage of special distributions offered by OZFs to keep as much money as possible in the OZ for 10 years so it becomes eligible for the third, and last, special tax benefit.
Fast forward to July 2029, the 10-year anniversary of the taxpayer’s OZ investment. Suppose their USD 10 million investment grows 7% a year and is now worth USD 19.7 million. If they elect to sell the fund, they would be permitted to eliminate any federal taxes on this USD 9.7 million capital gain. That is a substantial tax saving of USD 2.3 million based upon the current 20% federal capital gains (on financial assets) and the Medicare surtax on net investment income.
Let us now combine the defer, reduce, and eliminate benefits to see how this hypothetical investment in an OZF performs compared to investing in an S&P 500 Index fund. Using the example above, the OZF tax-deferral benefit enables the taxpayer to invest USD 10 million of art-related capital gains into an OZF. But if instead they invest in an S&P 500 fund (or another non-OZ investment), the gain will first be subject to federal taxes. After the 28% federal capital gains tax on art and the 3.8% Medicare surtax, they have USD 6,820,000 to invest in the S&P 500 fund. Using these initial investments, assume the S&P 500 fund grows 5% a year while the riskier OZF grows 7%. Let us now compare the value of these investments at five-, seven-, and ten-year holding periods. This enables an ‘apples-with-apples’ comparison of the after-tax proceeds the taxpayer would receive from each investment. As shown below, the after-tax value of the OZF is significantly higher than the S&P investment across all time periods, especially once the investor holds the investment for at least 10 years.
In 2024, the investor in the OZF has enjoyed five years of capital gains deferral and a 10% reduction in the amount of their initial art-related capital gain subject to federal tax. If they sold their OZ investment in 2019, they would pay federal capital gains taxes on the remaining deferred balance (USD 9 million) and capital gains on the growth in the value of the OZF. Using these assumptions, they would receive after-tax sale proceeds of USD 10.2 million. In the S&P alternative, they would keep USD 8.3 million after paying federal taxes on the gain in value. On an apples-with-apples after-tax basis, the OZF is worth 24% more than the S&P 500 fund. By 2029, the difference in after-tax values has jumped to 64%.
Despite the attractive tax benefits, it is essential for investors to conduct proper due diligence before committing to an OZF. Bad investments with good tax attributes are still bad investments.
Using Art and Culture to Stimulate Economic Growth
Governors and mayors across the USA now widely acknowledge and embrace art and culture as a tool to promote economic development. The National Governors Association, for example, published a report in 2009 framing best practices for using art and culture to stimulate economic development.
Since then, many cities across the country have created arts districts to promote community engagement, pedestrian traffic, and business development. No doubt many of these districts are in or adjacent to the 8,700 designated OZs. Investing capital there may be an especially profitable and culturally rewarding strategy, particularly if investors partner with local governments and philanthropic organizations to identify investments that will help accelerate local growth. For example, a taxpayer could help cultivate a local creative community by buying and converting an unused light manufacturing facility into a mixed-use space suitable for artists’ studios, galleries, coworking spaces, and retail stores. The Miami Design District, which was started more than 15 years ago, is a great example of how art and culture, when combined with private capital, can create housing, jobs, and a vibrant community.
Many art collectors are starting to evaluate the merits of using art-related capital gains to fund tax-advantaged long-term investments in OZs. To pursue this strategy, collectors will need to identify artworks in their collections with substantial capital gains and then negotiate selling agreements with auction houses and private galleries