At the end of 2017, when President Trump signed the 2018 Tax Cut and Jobs Act, he got rid of one of the biggest tax benefits for art collectors and investors. Section 1031 of the Internal Revenue Code, which allowed for like-kind exchanges, had previously been used as a tool for investors to defer capital gains on several types of investments. However, the reform limited the use of like-kind exchanges in deferring capital gains tax to only real estate investments. Previously, when an art collector wanted to sell a piece of art, as long as the collector used that money to acquire more art, it did not trigger a realization event. This meant that, despite the work of art that was sold having appreciated in value from the time of purchase, the art collector did not have to pay any capital gains tax. Instead the capital gains tax payment could continue to be deferred until the newly acquired work triggered a realization event. Deferring the capital gains tax essentially allowed the investor to further invest that money that would have otherwise been paid in tax, taking advantage of the time-value of money.
This section of the tax code had a two-fold effect on the art market that helped to fuel the industry within the United States. First, it brought expensive, renowned works of art into the hands of U.S. taxpayers because the buyers could use the art as a tool to continue to appreciate wealth with little concern about the capital gains tax (especially when the provision was combined with Section 1014, basis of property acquired from a decedent, if the work was held through the collectors life, when their heirs received the work of art they would not have to pay any tax on the gain prior to their inheritance of the work). Second, it stimulated turnover in the market. It encouraged an investor to sell a work they might otherwise hold onto in order to not trigger a taxable event, and when they did decide to sell a piece, it encouraged the seller to buy another art piece causing two transactions rather than just the one sale.
This change in the tax code may appear to only effect a small percentage of wealthy art collectors, however, these effects could have a negative impact on art appreciators across the U.S. regardless of whether they are in the art buying market. Art collectors often decide to loan their works of art to museums giving access to the public to appreciate the art that may otherwise sit in a private collection appreciated only by the work’s owner. If these works did not come into the U.S. though, they may not be as accessible for the U.S. public.
The elimination of this tax benefit has led art collectors to look for an alternative to Section 1031. Some art collectors think they may have found that in Opportunity Zones, which were also created in this same tax reform, but the first Opportunity Zones weren’t designated until April 2018, and the IRS and Treasury Department are working to provide further legal guidance in 2019. Opportunity Zones are “economically-distressed communities.” Investors can invest in real estate and businesses in those areas through Qualified Opportunity Funds (QOF). If an investor sells a piece of art and then invest the gains into a QOF within 180 days of the sale, they will be able to defer capital gains tax much like they previously did under 1031. Additionally, the longer the investor keeps their money invested in the Opportunity Zones, they will actually receive a step up in basison their gains so that when they do eventually pay capital gain it will be less than they would have paid if they triggered the realization event upon the initial sale. Therefore, Opportunity Zones may serve as a great alternative to art collectors in reducing capital gains tax, though it does come with the disadvantages of requiring their money to be tied up in a fund for a long period in order to seize the full tax advantages available through the provision and moves the money that may have gone to more artwork likely to real estate. Although some lawyers see the potential for investing in Opportunity Zones through the investment of a private-art museum, allowing an art collector to in fact use their money to buy more art.
While the wealthy, elite art collectors may be able to use an Opportunity Zone as a workable alternative tax benefit, it may result ultimately in a loss to the public. Housing art in private art museums often does not allow for the same access and serve as the same educational resource as most public museums. The access provided to the private art museums is usually limited in terms of numbers of days opened and numbers of people allowed in. The use of opportunity zones may result in a loss of investment in the art market, or if not, a loss in the public benefit the purchases made by art collectors currently provide through their museum loans.