Collectors lamented that the 2017 Tax Cuts and Jobs Act eliminated our ability to do 1031 Exchanges with our collector cars. After 2017, 1031 Exchanges are limited to real estate. This also means that doing a straight exchange with a car dealer doesn’t work either. That is, going to a Porsche dealer and trading your Ferrari for a Porsche is now a taxable transaction.
But the new law targeting moving companies also produced an unexpected new planning technique that is attracting a huge amount of attention. Under the new tax rules, you can defer the recognition of gain on the sale of any property (including cars) to the extent that the gain is reinvested in either Qualified Opportunity (QO) Zone property or in a QO Fund.
If the QO investment is held at least five years, 10% of the deferred gain is canceled; if held at least seven years, 15% is canceled; if held at least 10 years, the entire gain is canceled.
In several respects, this is better than a 1031 Exchange.
First, you don’t need to use an escrow or an accommodator. You can sell your car, put the money in the bank, and you then have 180 days after the sale to decide whether to reinvest in a QO investment.
Second, there is no like-kind requirement, so you don’t have to trade cars for cars. You can sell your cars and reinvest it into real estate.
Third, you don’t have to reinvest all the sales proceeds. 1031 Exchanges carried a counter-intuitive rule: Any cash you ended up with was taxable. QO investments only require that you reinvest the gain.
Here’s an example. Say you bought your LaFerrari new for $1.5 million and you just sold it for $3.5 million — a gain of $2 million. To have avoided tax with a 1031 Exchange, you would have had to reinvest the entire $3.5 million in replacement cars. But to avoid tax now, you only need to reinvest the $2 million gain in a QO investment. You can put the $1.5 million back in your bank account, tax-free. If you only reinvest $1 million, you pay tax only on the $1 million you did not reinvest.
QO Zones are ZIP code areas that are designated as low-income communities by the governor of the state, and they exist in every state. The actual designations are rather surprising — for example, most of downtown Portland, OR, is within a designated QO Zone.
QO Zone property is defined as any real estate located within a QO Zone, any interest in a business whose tangible property is located in a QO Zone, and a QO Fund. A QO Fund is a partnership, LLC or corporation which invests in QO Zone property.
There are two catches to this.
First, it isn’t enough to just acquire the QO Zone property — you have to essentially double your investment by building, remodeling or otherwise improving the property.
Second, there is uncertainty about what happens when the new law sunsets in 2026. Your deferred gains may be taxable then, or the law may change to extend the deferral, or something else might happen.
There are many existing QO Funds today, and more are being created every day. I would expect all of them to have all the same negatives as every other type of investment fund — sales charges going in, management fees charged to the fund each year, equity shares given to the promoters, lack of control, lack of marketability, etc. However, it is entirely permissible for you to create your own QO Fund.
Use of a QO Fund may provide added flexibility with investment changes.
There hasn’t been enough time for all of this to be fleshed out, but it appears that if you invest directly in QO property, any deferred gain is recognized when the QO property is sold or exchanged. That means that you can’t use a 1031 Exchange to avoid recognition. But if the replacement property is QO property, it would seem that would generate a new QO Zone property deferral of that gain. While that would seem to reach the same end result as a tax-free exchange, the difference would seem to be that the five-, seven- and 10-year holding periods would reset.
With a QO Fund, the deferral continues so long as the QO Fund is retained, and the five-, seven- and 10-year periods are tied to the ownership of the QO Fund interest. That suggests that the QO Fund could make internal 1031 Exchanges into replacement QO Zone property without affecting the five-, seven- and 10-year periods.
Better than nothing
Despite the uncertainties and limitations, QO investments are a viable alternative for the car collector. You can sell your car, keep the cash, and pay 33% or more income tax on the gain. Or you can move the gain into a QO investment and at least defer the gain until 2026. If you are comfortable with real-estate investing, this can be an easy opportunity to avoid paying income tax on the sale of your collector car. ♦
JOHN DRANEAS is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney. He can be reached through www.draneaslaw.com.