If you’ve traded art in the US in the past decade, you will be aware of one of the leading drivers of art sales – the Section 1031 Exchanges. Also known as ‘Like-Kind exchanges’, they represented a tax provision that allowed individuals to buy and sell assets of a similar nature – for example property or art – over a certain period without incurring capital gains tax on those transactions.
Owners of art and collectibles could use a 180-day window to roll the proceeds from the sale of an asset or collection of assets into another similar asset or collection without incurring capital gains tax. Naturally, this became a well-trodden route for art flippers.
However, a provision in the Tax Cut and Jobs Act of 2017 changed that. The Tax Cut legislation limited the use of Section 1031 to real or fixed property, excluding personal property, leaving art and other collectors without a tax-efficient solution for the disposal of assets.
Given the higher tax rate associated with the sale of art and collectibles as compared with regular capital assets (28% versus 20%), the elimination of the 1031 option has impacted the net proceeds to art collectors.
Nick Parrish of Cresset Partners, a US-based investment firm, said: “Now, when an individual sells a piece of art, there’s actually a higher tax rate than on the sale of other assets – almost a 30 percent tax bill – which is problematic for people. It’s slowed volume in art sales.”
Shortly after the US government revoked the Section 1031 Exchanges, there came Qualified Opportunity Zones (QOZs). These are areas in the United States that have been classified as ‘economically depressed or underserved’, in which private investors can make long-term investments and enjoy tax breaks, while driving socio-economic development at the same time.
There are over 8,700 of these QOZs – from a few city blocks to larger areas – all across the US. Approximately 30% of them are in core urban areas, 25% in suburban areas and the rest in rural areas. They were determined based on levels of employment, income and other economic metrics from the last US income census. Nick Parrish cited parts of Brooklyn in New York City, downtown Portland, in Oregon and Nashville as some of the urban areas included.
Real estate investments in OZs remain the least complicated way in which to invest money through a QOZ fund, particularly if one is buying land and building on it from scratch.
Parrish said, “You can also own businesses in these zones. But there are more limitations here. For example, how much of your income has to be generated in that zone and how many employees are based in that zone.”
What this means for art collectors
With the demise of Section 1031 Exchanges, art collectors who are either citizens of the US or foreign investors – but US taxpayers nonetheless – lost the opportunity to sell and re-invest the proceeds from art sales without creating tax liabilities.
The introduction of Qualified Opportunity Funds (QOFs) – such as Cresset’s: Cresset-Diversified QOZ Fund, gives art collectors a chance to diversify their financial portfolios while investing logically and with tax benefits.
Let’s assume for argument’s sake that you own a Gerhard Richter purchased at $12 million, which sells for $14 million some years later. Instead of immediately paying taxes on that gain of $2 million, you can now invest all or part of the gain in a QOZ fund and delay paying the taxes on that gain until at least 2027. At that point the taxable amount would be reduced by 15%, to $1.7 million. Finally, if you hold the QOZ investment for at least 10 years, you escape capital gains tax on the $2 million entirely.
It is common knowledge that art collectors buy art they are passionate about. But, Parrish added: “They think about what they’re buying, what they’re selling and how much of a return of value they have on that. I think this program will initially be adopted by that group.”
And so, while it’s not adding to their collections or causing them to buy more art, it is allowing them to diversify into other asset classes in a way that’s beneficial to them.”
Parrish says another way to go is investing in galleries and warehouses in the QOZs, given they are in many “trendier, cutting edge” parts of most cities.
However, it is imperative for QOZ Funds to invest in operating businesses or real estate located within one of the QOZs. Information about further specifications can be found on the IRS’s website. And of course, the key for QOZ investors is to identify investment opportunities that are attractive without the tax benefits.
There is a wide range of quality in the zones and many factors to ensure before investing. QOZs may have replaced Section 1031 exchanges in kind, but whether they are of ‘like-kind’ has yet to be seen.