Significant wealth creation over the past two decades has fueled an increase in the number of art collectors and enthusiasts globally. Since 2000, the number of billionaires worldwide has quadrupled, driving increased participation in art and collectibles markets. According to the 2019 Art Basel and UBS Global Art Market Report, global art sales totaled approximately $67.4 billion in 2018, reaching their second highest level in a decade. With increased interest in art and record capital going into the market, art prices have skyrocketed, breaking numerous price records.
The top ten most expensive paintings sold at auction on an inflation-adjusted basis have all occurred in the last 10 years. In 2017, Leonardo da Vinci’s Salvator Mundi smashed previous records, selling for $450 million, becoming the most expensive piece of art ever sold. Earlier this year, Jeff Koons’ Rabbit was sold by Christie’s for $91.1 million, becoming the most expensive work sold by a living artist.
While these pricing dynamics benefit active collectors of and investors in art, they can also create significant tax liabilities for collectors who sell highly appreciated works. As art collectors increasingly look at art as an investment, not just a labor of love, like any other asset, they need to consider their potential returns on both a before and after tax basis.
To understand the potential impact on a collector, consider the sale of Jean-Michael Basquiat’s Flesh and Spirit, which was sold in May 2018 at a Sotheby’s auction for $30.7 million. The seller allegedly purchased the piece 35 years ago for $15,000. Assuming a capital gains rate of 28% on art & collectibles and a 3.8% net investment income tax, the seller would face a $9.75 million tax bill. While an extreme example, many collectors who own highly-appreciated art collections will face a significant tax bill when they sell their art.
Until 2017, collectors were able to utilize Section 1031 “Like Kind” Exchanges to roll the proceeds from the sale of an asset or collection of assets into another similar asset or collection without incurring a capital gains tax. A provision in the Tax Cut and Jobs Act of 2018, however, changed that. The Tax Cut legislation limited the use of Section 1031 to only real 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 & collectibles as compared to regular capital assets (28% versus 20%), the elimination of the 1031 option has the ability to significantly impact net proceeds paid to art collectors.
While the Tax Cut and Jobs Act eliminated the use of 1031 exchanges for collectors, it created another, potentially more advantageous solution for collectors: Qualified Opportunity Zone (QOZ) investments. Passed as part of the Tax Cuts and Jobs Act of 2017, QOZs are areas across the U.S. that have been designated by the U.S. government as economically depressed or underserved. To incentivize private investment in these communities, the QOZ legislation created sizeable tax breaks for investors who make certain types of long-term investments that have the potential to promote economic growth in these zones.
Investments in QOZ Funds offer three core tax benefits:
- Deferral of the tax on the sale of the artwork, potentially through 2026.
- 15% reduction of tax if investment is held for seven years, or 10% if held for five years.
- Complete avoidance of tax on the appreciation of the QOZ investment if held for at least 10 years.
Over the past year, Qualified Opportunity Zone investments have emerged as an attractive alternative to Section 1031 “Like Kind” Exchanges, even for real estate investors who have been the most frequent users of Section 1031. They offer several key advantages for art collectors as well. This is a result of four key factors that differentiate QOZ investments from Section 1031 exchanges:
- A collector can keep his or her tax basis (or cash paid) in the artwork and only invest the amount of gain from the sale of the artwork into a QOZ Fund. The collector can use this cash in any matter he or she sees fit, including the acquisition of additional artwork.
- An art collector doesn’t have to die in order to receive a full step-up to fair value. If he or she holds the QOZ investment for at least 10 years, then the investment will receive a full step-up to fair value, and therefore, be excluded from tax.
- For an investor, a QOZ Fund investment is significantly less complex than a Section 1031 exchange. There are no qualified intermediaries, 45- day identification periods or complicated structures involved with a QOZ investment. A collector simply sells his/her artwork and contributes the gain into a QOZ Fund within 180 days.
- A collector can get instant diversification and, often times, cash flowing assets with good risk adjusted investment return profiles.
Collectors can utilize QOZ Fund Investments to reduce or potentially eliminate the tax bill from the sale of artwork, while diversifying their investment portfolio and retaining some assets to purchase additional artwork. Collectors can take only the gain portion of the sale and invest it into a QOZ Fund, while using the basis in their investment to purchase additional artwork. In addition, they would now own a diversified asset that, if held for 10 years, would grow tax free. Furthermore, they have deferred and reduced the taxes due on the original sale of the artwork.
Consider the following hypothetical example:
A collector purchases a piece by Mark Rothko in 2008 for $20.0 million. In 2018, they sell the piece at auction for $40.0 million. Upon closing the sale, assuming the seller is U.S. based or subject to U.S. taxation, they would owe the government $6.3 million. Instead of paying the tax bill, the seller could invest up to $20 million dollars (the sale price less the purchase price) into a Qualified Opportunity Zone Fund.
The seller would have $20 million remaining to invest in additional artwork. They would also diversify their overall financial portfolio by owning a portfolio of private company investments or real estate that is potentially growing tax free.
The tax free growth can be significant and add approximately 4% to 5% per year to the overall investment return. Additionally, the seller would defer the tax bill from the sale of the Rothko piece until 2027, reducing the amount owed to $5.35 million.
In order to qualify for the aforementioned QOZ benefits, QOZ Funds need to invest in operating businesses or real estate that are located within one of the 8,766 zones across the U.S. The key for QOZ investors, however, is to identify investment opportunities that not only stand on their own merit, but are also attractive without the tax benefits. There is wide dispersion in the quality of the zones, though opportunities exist for skilled investors to identify high-quality projects or businesses located in attractive markets. It is important for investors to consider their options carefully and select experienced partners with the requisite skill and resources to identify the appropriate QOZ investments and navigate the complexity of the QOZ regulations.