The Tax Cuts and Jobs Act signed into law in late December 2017 created a new tax benefit that is particularly beneficial to U.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 in Qualified Opportunity Zone Funds designed to spur economic activity in economically distressed communities. The longer investors keep their investments in these funds, the greater the tax benefits they receive.
In the balance of this note, I explain how this program works and why capital gains from the prudent sale of art this year is a tax-efficient way to fund Opportunity Zone investments. I then share some thoughts for how philanthropy, art, and culture can be combined with OZ investments.
HOW OZ INVESTMENTS WORK
Opportunity Zones (“OZs”) are economically-distressed communities where new investments that meet certain criteria are now eligible for preferential tax treatment. As of December 2018, nearly 9,000 communities across the country have been certified as OZs. They exist in every state, every 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, 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 62; with Staten Island bringing up the rear with 8. Approximately 1.2 million people live in these designated areas. If you would like to explore these and other OZs, click here for an interactive map created by the Economic Innovation Group, a bipartisan public policy organization.
The cornerstone of the OZ program is a new type of investment vehicle called an Opportunity Zone fund (“OZ fund”). Taxpayers who sell appreciated assets like stocks, real estate, or fine art can receive three special tax benefits if they roll their gains into an OZ fund within 180 days. First, they can defer federal taxes on these gains until December 31, 2026, or until they sell their Opportunity Fund 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 5 years prior to December 31, 2026, they can reduce their deferred gain subject to federal taxation by 10 percent, which will lower the ultimate tax they paid on that gain. If they hold the investment for 2 more years, the tax liability is reduced an additional 5 percent, for a total reduction of 15 percent. Third, they can eliminate federal taxes due on OZ fund profits if they hold the investment for at least 10 years.
OZ fund tax benefits are only available to taxpayers who fund their investments with capital gains from asset sales. While a taxpayer can elect to invest more cash into an OZ fund, the tax benefits are limited to the portion of their investment 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 Great Recession. The 5, 7, and 10-year tax incentive triggers are designed to help keep the money in these communities for the long haul.
To be an eligible investment, an OZ fund must acquire equity interests in a business, real estate project or business assets 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 need to be either new real estate projects, or if an existing real estate asset, they must make improvements in the property equal to the value of their initial investment. Some eligible OZ fund investments include providing growth capital to mid-sized companies located in OZs; equity capital to convert an underused warehouse into a mixed-use development; and funds to develop and lease new affordable housing.
ART-RELATED CAPITAL GAINS EFFECTIVE WAY TO FUND OZ INVESTMENTS
Because the Federal capital gains taxes on art and collectables is 28 percent, higher than the 15 or 20 percent rate on financial investments, gains from the sale of fine art are a particularly tax-efficient way to invest in Opportunity Zone Funds. Let’s walk through a hypothetical example of how these benefits work with art-related capital gains.
Suppose a taxpayer sells several artworks during the Spring 2019 auction season, resulting in $10 million of long-term capital gains. They invest these gains into an OZ fund within 180 days. For purposes of this example, they make their investment in July 2019 after receiving sale proceeds from the auction house. At the current 28 percent federal capital gains rate for art and collectables, this enables the taxpayer to defer for now $2.8 million that would otherwise be remitted to the IRS. 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 percent tax. As a result, the taxpayer retains an additional $380,000, for a total federal tax deferral of $3,180,000. Depending on the state where they live, the taxpayer may have to pay state-based capital gains taxes in tax year 2019 on the $10 million gain; the OZ tax deferral only applies at the federal level. The value of the federal tax deferral to the taxpayer depends on two things: the length of time they hold the OZ fund 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 OZ fund (which would be July 2024), the taxpayer is eligible to reduce the value of their deferred capital gain by ten percent, or $1 million. After seven years, or July 2026, they can reduce it another five percent. If the taxpayer then sold their OZ fund, they would pay federal taxes on an $8.5 million gain, rather than the original $10 million. That’s a savings of $477,000 for holding the investment for seven years based on their 28 percent federal capital gains tax rate (on art) and Medicare surtax rate of 3.8 percent. If they continue holding their OZ investment, the taxpayer will need to pay capital gains taxes on the $8.5 million gain when the deferral period ends on December 31, 2026. But taxpayers will likely elect to finance this tax payment with debt or take advantage of special distributions offered by OZ funds, to keep as much money as possible in the OZ for ten years so it becomes eligible for the third, and last, special tax benefit.
Fast forward to July 2029, the ten-year anniversary of the taxpayer’s OZ investment. Suppose their $10 million investment grows 7 percent a year and is now worth $19.7 million. If they elect to sell the fund, they would be permitted to eliminate any federal taxes on this $9.7 million capital gain. That’s a very substantial tax savings of $2.3 million based upon the current 20 percent federal capital gains (on financial assets) and the Medicare surtax on net investment income.
Let’s combine the defer, reduce, and eliminate benefits to see how this hypothetical investment in an OZ fund performs compared to investing in an S&P 500 fund. Using the example above, the OZ fund tax deferral benefit enables the taxpayer to invest $10 million of art-related capital gains into an OZ fund. 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 percent federal capital gains tax on art, and the 3.8 percent Medicare surtax, they have $6,820,000 to invest in the S&P fund. Using these initial investments, assume the S&P 500 fund grows 5 percent a year while the riskier OZ fund grows 7 percent. Let’s now compare the value of these investments at 5, 7, and 10-year holding periods. This enables an “apples to apples” comparison of the after-tax proceeds the taxpayer would receive from each investment. As shown below, the after-tax value of the OZ fund 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 OZ fund has enjoyed 5 years of capital gains deferral and a 10 percent reduction in the amount of their initial art-related capital gain subject to federal tax. If they sold their OZ investment this year, they would pay federal capital gains taxes on the remaining deferred balance ($9 million) and capital gains on the growth in the value of the OZ fund. Using these assumptions, they would receive after-tax sale proceeds of $10.2 million. In the S&P alternative, they would keep $8.3 million after paying federal taxes on the gain in value. On an “apples-to-apples” after-tax basis, the OZ fund is worth 24 percent more than the S&P 500 fund. By 2029, the difference in after-tax values has jumped to 64 percent.
Despite the attractive tax benefits, it is essential for investors to conduct proper due diligence before committing to an OZ fund. Bad investments with good tax attributes are still bad investments.
USING ART AND CULTURE TO STIMULATE ECONOMIC GROWTH
Governors and mayors across the country 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:
“Arts and culture-related industries … provide direct economic benefits to states and communities: They create jobs, attract investments, generate tax revenues, and stimulate local economies through tourism and consumer purchases. These industries also provide an array of other benefits, such as infusing other industries with creative insight for their products and services and preparing workers to participate in the contemporary workforce. In addition, because they enhance quality of life, the arts and culture are an important complement to community development, enriching local amenities and attracting young professionals to an area.”
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 artist studios, galleries, co-working 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 jobs, housing, and a vibrant community. Click here to learn more about the history of the design district.
In closing, many art collectors are starting to evaluate the merits of using art-related capital gains to fund tax-advantaged long-term investments in Opportunity Zones. 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. Art Fiduciary Advisors assists clients on the sale of art so they can be assured of maximizing sale proceeds in the complex and opaque art market. We would be happy to discuss any questions you may have about the art market and the best way to sell valuable works of art.
Doug Woodham is the Managing Partner of Art Fiduciary Advisors, a NY-based firm focused on providing art-related financial advice to collectors and institutions. Earlier in his career, Doug was President of Christie’s for the Americas and a Partner with McKinsey & Company. He is also the author of the best-selling book Art Collecting Today: Market Insights for Everyone Passionate About Art (2017).
This article is for educational and informational purposes only and is not intended and should not be construed as legal or tax advice. Because of the complicated nature of these investments, consult with your tax and legal advisors before committing any funds. Art Fiduciary Advisors does not provide tax or legal advice.