Can a new tax break for art collectors replace a prized benefit that was stripped from the books last year?

One year after Congress killed a wildly popular provision favored by art flippers, a new tax benefit has emerged under the Trump administration’s tax plan, so-called “Opportunity Zones,” which came into effect in late December 2017. These zones are economically distressed communities where new investments may be eligible for preferred tax treatment. The first set of Opportunity Zones were designated this past April, and now appear in parts of all 50 states, the District of Columbia, and five US territories. In New York state, numerous sections of the Bronx, Albany, Erie, and Dutchess county are designated (a more than 300-page list of areas is available online).

So where does art come into the equation? The regulations allow for tax deferment on proceeds from the sale of an appreciated asset—such as a Picasso painting—if the seller uses the money to invest in an Opportunity Zone. These new zones were first established on April 9 and lawyers have slowly been figuring out how to apply them to art.

As One Loophole Closes, Another Opens

Last year, Congress delivered a blow to some savvy collectors when its new tax plan tightened an obscure and complex provision in the tax code known as “1031” or “like-kind” exchanges, which allowed investors to immediately avoid capital-gains tax by using the proceeds from the sale of a piece of property to purchase another, similar piece of property within a short period of time—a handy mechanism for art flippers.

Although the rule is most commonly used in pricey real estate transactions, it became popular among art collectors during the recent market boom, not only because the value of art skyrocketed to unprecedented levels, but also because art remains one of the few assets that incurs the highest capital gains rate (28 percent). The new tax law limited the use of these “swaps” to real estate, leaving art collectors like Stefan Edlis, who described his reliance on the practice in the recent HBO documentary The Price of Everything, out of luck.

Now, Opportunity Zones may offer art collectors a second—though less enticing—chance at tax deferment. “We’ve been tracking Opportunity Zones very closely,” says Diana Wierbicki, head of the art law practice at Withers Worldwide. “They are attractive as a deferral from capital gains but not necessarily as good as 1031s.”

Others, meanwhile, are more enthusiastic about the new opportunity. “The prospect of making a profitable investment—and on a tax deferred basis—is tantalizing to investors,” says Thomas Danziger, a partner at the firm Danziger, Danziger & Muro. “We have clients who view Opportunity Zones as the new economic erogenous zones.”

How It Works

Want to invest in an Opportunity Zone? Here’s how it works. Say you previously bought a Warhol for $10 million and you now sell it for $11 million. Instead of paying tax on the $1 million gain, you take the $1 million gain and invest it in an opportunity fund in 2019. If you keep it in that fund until 2026, then you get a 15 percent basis bump up (an adjustment in the value of the gain that lowers the tax owed) and you then pay the tax on the deferred gain of $750,000. If you keep it in the fund for at least 10 years, you shelter any appreciation from tax when you ultimately sell. So you would be deferring the date that you have to pay tax on the gain and decreasing the amount of the gain subject to tax.

According to IRS guidelines, the gain from the sale must be invested within 180 days. If the opportunity fund investment is held for longer than five years, there is a 10 percent discount on the amount owed. If held for more than seven years, that 10 percent becomes 15 percent. Further tax benefits can accrue if the collector holds the investment for at least 10 years.

The main difference for fans of the 1031 provision is that, with an Opportunity Zone, the art owner must give up or sell the artwork without welcoming a new one to the collection. The gain they make on the sale has to be parked in an approved fund and remain there for several years.

Not surprisingly, experts saw a flurry of 1031 exchanges initiated at the end of 2017 once people realized the window was closing, says Wierbicki. (Under the rules, investors had to complete an exchange within six months of the December 31, 2017 expiration date, so some activity extended into 2018.) “It almost felt like a game of musical chairs,” she says. Knowing that the the provision was about to disappear, people were looking at their collections and asking themselves: “Am I happy with what I have? Or do I want one more go-round?”

“Ultimately, the decision is theirs to make,” says Wierbicki. “The taxes are important, but at the end of the day you don’t want to do a trade just to end up with a work you enjoy less or that is a worse investment.”

Different Animal?

Yet another critical difference between 1031s and Opportunity Zones: Instead of reinvesting in art, an individual is shifting money from the art market to the real estate market.

Whether or not the real estate in the Opportunity Zone is a good underlying investment is a key question, Wierbicki says. “Is the tax incentive going into this good enough? If you have a loss, the initial tax deferral may not be as valuable,” she says.

The proposed regulations regarding Opportunity Zones are still being finalized. According to the IRS website, it will be providing further details, including additional legal guidance about Opportunity Zones, in the months to come.