Locke Lord QuickStudy: Art Collectors: Consider this before your next sale

An art collector looking to sell or exchange one or more works from his or her collection may be able to defer recognition of the capital gains on the transaction thanks to a recent change in the tax laws.

Background

Prior to enactment of the Tax Cuts and Jobs Act (P.L. 115-97), investors could avoid capital gains on the sale or exchange of an investment through like-kind exchanges, which were permitted under Section 1031 of the Internal Revenue Code. When a taxpayer sold or exchanged a property and purchased a similar property within a specified timeframe, recognition of gain on the initial sale or exchange was excluded from gross income. The Tax Cuts and Jobs Act, which was signed into law by President Trump in December 2017, restricts future application of Code Section 1031 to transactions involving real estate. However, new Code Section 1400Z-2 provides an opportunity for art collectors wishing to sell an appreciated work of art to continue to avoid recognition of capital gains by investing in qualified opportunity funds following the sale.

New Rules for Investments in Qualified Opportunity Funds

Under the new law, a taxpayer who would otherwise recognize a gain upon the sale or exchange of property in the tax year of the sale or exchange may exclude a portion of the gain from gross income by reinvesting the gain in a qualified opportunity fund within 180 days of the sale or exchange. The deferred gain must be recognized on the date on which the investment in the qualified opportunity fund is disposed of or December 31, 2026, whichever is earlier.

A qualified opportunity fund is an investment vehicle that is set up as a partnership or a corporation for investing in eligible property that is located in a qualified opportunity zone. All 50 states, the District of Columbia and five U.S. territories have designated opportunity zones, which represent population census tracts in low-income communities. Offering tax incentives for investments in economically-distressed communities is intended to spur economic development and job creation.

Amount of Deferred Gain

The amount of gain recognized on the subsequent disposition of the qualified opportunity fund depends on how long the taxpayer holds the property.  If the taxpayer holds the investment for at least five years, 10% of the deferred gain may be excluded from gross income and, if the taxpayer holds the investment for at least seven years, the amount excluded rises to 15%. Furthermore, if the taxpayer holds the investment in the qualified opportunity fund for at least 10 years, the taxpayer is eligible for an increase in the basis of the qualified opportunity fund investment equal to its fair market value on the date that the qualified opportunity fund investment is sold or exchanged, resulting in no capital gains on the sale.

These tax incentives are temporary and will not apply to any sale or exchange that occurs after December 31, 2026. Before your next sale, we would be happy to discuss your options for reducing your tax liability, including the benefit of investing in qualified opportunity funds.