Qualified Opportunity Funds can help mitigate crypto art’s hefty tax burden.
Like most sectors, the art industry has struggled to adapt and grow through the challenges brought by Covid-19. One bright spot is the crypto art market’s growth and the individual works known as NFTs (Non-Fungible Tokens). Through NFTs, artists can create unique works of digital art. Just as bitcoin can hold scarcity value without being a physical coin, digital works of art can maintain scarcity value too. The NFT market is new, having only emerged over the last five years. This past year it really took off, likely with a boost from the pandemic keeping everyone cooped up in front of their computers. Prices for crypto art have been setting records this year, led by artist Mike Winkelmann, AKA Beeple, recently sold his NFT “The First 5000 Days” for a record $69.3 million.
NFTs will be a game-changer for the art market because they are free from traditional storage or transportation costs. You can buy and sell NFTs in the same day like a share of stock. This new ability will lead to more transactions, more speculation, and shorter holding periods. But in one area, NFTs are far from frictionless, capital gains liability. Fortunately, the federal government created qualified opportunity funds to encouraging those with recent capital gains to potentially defer and even eliminate capital gain liability.
Qualified Opportunity Funds (QOFs) are an Important Wealth Management Tool for Art Investors
The need for QOFs for investors in art is acute for a couple of reasons. First, most assets have a top capital gains rate of 20% but art and other collectibles have been taxed at a higher 28% rate since “The Taxpayer Relief Act of 1997”. Second, until “The Tax Cuts and Jobs Act of 2017” (TCJA) art investors were able to defer these taxes through 1031 exchanges (AKA “like kind exchanges”)” which allowed the tax liability on a sale of a piece of art to be tax-deferred indefinitely if the proceeds were reinvested in a “like kind” investment. So art investors used to pay no tax by deferring it, but now they have to pay tax and get hit with a higher tax rate than everyone else. Can it get worse? Yes, it can! To receive long term tax rates, you need to hold an investment for a year and a day. Because crypto art can be traded with greater ease on markets like OpenSea and even Christie’s, this will inevitably lead to greater transaction volume and more short-term gains that carry the highest potential tax rates.
At the federal level, short-term gains are taxed at the ordinary income rates, which for the highest earners is 37% plus the net investment income tax of 3.8%. Using New York as an example, a top tax bracket resident selling art for a gain would owe state tax of 8.8%. For a total tax bill of 49.6%. New York is fully compliant with federal opportunity zone incentives, so all 49.6% of taxes are potentially deferrable with an investment into a QOF. Most, but not all, states offer QOF investment incentives.
Qualified Opportunity Funds (QOFs) Can Replace 1031 Exchanges for Art and Collectibles
The same legislation that eliminated 1031 exchanges for collectibles, including art, created QOFs – The Tax Cuts and Jobs Act of 2017. After two long years of debate, the finalized rules for QOF tax incentives were completed in December of 2019 and are ready to impact the tax efficiency of art transactions positively. Reinvesting capital gains into QOFs allows collectors to keep 100% of their investment proceeds working for them potentially until 2026 taxes are due in the spring of 2027.
For art collectors, a tax tool that can replace like-kind exchanges could not come fast enough. QOFs can be a highly efficient tax tool, but they do not work the same way as 1031s did. One is not necessarily better than the other. They each have their strengths and weaknesses. Using QOFs will be an adjustment, but the reward can yield significantly higher after-tax returns for collectors.
One big difference between 1031s and QOFs is that investors only need to reinvest the capital gain portion of the proceeds into a QOF to defer the entire capital gain liability. Like-kind exchanges required both the principal and the gain to be reinvested. Investors are now free to use the principal portion any way they like: new art acquisitions, increased liquidity, vacation home purchases, etc. In general, rules for QOFs are less structured than 1031 exchanges and allow for more optionality and creative solutions. For instance, with QOFs, you no longer need to have an intermediary because there is no requirement to trace funds. If you have a cashless capital gain, it is no problem to use funds from another source. This kind of flexibility can be found throughout the QOF rules.
Opportunity Zone Incentives Strive to Promote Social Good
The idea behind the creation of QOF incentives is to encourage those with capital gain liability to reinvest their taxable proceeds into designated low-income communities in need of capital to kick start their economies and promote social equality. Qualifying investments must be made through a QOF, which is how the IRS keeps track of compliance. To be eligible for benefits, collectors typically need to reinvest their capital gains into a QOF within 180 days, which is similar to how 1031 exchanges worked. Although there are some short-term benefits for investors, the most significant incentives are gained for those who can maintain their investment for ten years or greater. For these long-term investors, QOFs offer significant benefits.
QOFs have the rare ability (tax superpower) to not only defer but eliminate some capital gain liability. Here are the three main tax benefits:
1) The tax liability on the original capital gain is deferred until you sell the QOF or December 31, 2026, whichever comes first.
2) Once you have held the QOF investment for five years, you can elect to take a 10% step-up in cost basis, eliminating 10% of the capital gain liability.
3) Once the QOF invested has been held for ten years, you may elect to take a 100% step-up in basis, eliminating all capital gain liability. This benefit terminates when you sell your QOF investment or December of 2047, whichever comes first.
The first two benefits help mitigate the tax pain of realizing the initial capital gain, while the third benefit allows investors to compound growth in the new QOF investment without any capital gain liability for decades – it is a powerful wealth management tool. These benefits are available to any individual who owes capital gains to the IRS regardless of their residence. The law also allows an expansive list of entities to participate, so estates, trusts, partnerships, C corporations, S corporations, and REITs are all eligible.
How significant are Qualified Opportunity Fund tax incentives for Investors?
According to many market observers, taken together, the QOF benefits will add about 3% annually to an investment that otherwise would have returned 7 or 8%. So, your 7% return becomes a 10% return, and your 8% return would become an 11% return – the QOF is increasing the return on your capital by roughly 40% year after year. For long-term investors, the compounding effect of the tax benefits can be truly gigantic. QOFs can invest in any of 8700 opportunity zone located across the United States. Opportunity zones themselves are designated low-income census tracts with populations of 2000 to 8000. An opportunity zone might be a whole town in a rural area or just a neighborhood in an urban setting. Most opportunity zones, perhaps 85 or 90%, focus on real estate, but they can invest in operating businesses as well.
The other major draw of QOFs is that, with the demise of like-kind exchanges for art, it is the only game in town other than paying the tax. There are exceptions, of course. If you are thinking about generational wealth, trust and estate planning can deliver a good outcome. Unfortunately, these options often require planning. For most investors and most transactions, QOFs will be the clearest way to deliver a tax-efficient result.
Wealth Management for Art and Collectibles Has Changed
Historically, many investors have used art to store wealth. The use of like-kind exchanges incentivized reinvestment of all proceeds back into the same asset types. Not surprisingly, this often led to very concentrated portfolios for some investors. QOFs, on the other hand, encourage diversity of assets because it mitigates the tax consequences for investors to exiting highly appreciated investments, and it allows a broader redeployment of the proceeds. This is mostly a good thing, but it can be difficult for determined collectors to reinvest the gain from the sale of collectibles back into similar assets. For example, if a collector sells a NFT for a profit, the collector could either choose to pay the capital gain tax or keep their money working for them by reinvesting the gain into a QOF. After deciding to use a QOF, the collector would then be free to reinvest the principal portion of the proceeds any way they choose, including more digital art. Investing the gain back into art in a QOF-compliant way is a bit trickier. The QOF needs to invest in a business or commercial property located in an opportunity zone. These requirements make reinvesting the gain back into art an especially digital art, challenging. How do you invest in a piece of art that also qualifies as a business? Most QOFs will invest in commercial real estate but do not be surprised if you see a few museums popping up in opportunity zones.
QOFs have the potential to take some of the sting out of the loss of 1031 exchanges and elevated tax rates for crypto art investors. I believe the use of QOFs will catch on with both traditional and crypto art investors. However, suppose the art world fails to embrace opportunity zone benefits. In that case, the market runs the risk of seeing the “lock-in effect” where artworks that would have been sold are “warehoused” just to avoid triggering the tax liability. There will be a learning curve, but QOFs are poised to impact the traditional and especially the crypto art markets substantially.
You can learn more about opportunity zones and our fund, Park View OZ REIT, from our website, where you will find more QOF-related content, our offering document, investor presentation, and subscription agreement. The idea behind Park View OZ REIT is to offer our investors access to opportunity zone incentives and the qualified business income deduction through an institutional quality commercial real estate portfolio, all in a fund that has freely tradable shares, low fees, and a positive social impact.
As always this is not tax or legal advice. Please consult with your investment advisor.