A Soft Market and Hard Tax Choices

By now, everyone knows the collector car market has softened. The harder question is what will happen next. If you liken the collector car market to the stock market, you should be bullish. Every time the stock market has lost substantial value, as it recently did after the Brexit vote, it has quietly bounced back to regain the lost value — and then some. To you, today’s collector car market is a buying opportunity. If you see the collector car market as reacting to broader demographic forces, then you might think this is permanent. The demographic force we are talking about is the aging of the Baby Boomers. Younger generations either show reduced interest in collector cars — or their interest lies in different cars than the Boomers are drawn to. Great examples of changing generational preferences are Model As and Baby Birds. This column is not the one you read to get your market information, but “Legal Files” does speak with a variety of collectors and can share some anecdotal information. There are still some collectors buying cars as pure investments — and they firmly expect values to continue to increase over time — although perhaps not as rapidly as we have seen recently. On the other hand, there are some collectors who have concluded that 10, 20 or 200 cars are just too many, and they are reducing their collections to a smaller group of cars they can use and enjoy. Interest in tax opinions on the proper capital gains rate to pay (20%, not 28%) is up. Interest in 1031 Exchanges seems down because they simply perpetuate the investment in collector cars. Again, you will get more reliable observations about the market elsewhere in this issue, but if you believe that “Legal Files” has its finger on some pulse, then you might conclude that a significant number of collectors are selling off at least some of their cars.

To sell or not to sell

Almost a year ago, I was working in my garage and recognized that every car I owned had appreciated quite strongly — even my Ferrari 308. The obvious thought was that I should sell most everything before values went further down. Later, if I wanted to, I could replace the cars at lower values — and then ride the appreciation curve all over again. That’s a logical plan, but let’s do the math. Federal capital gains tax is 20%, but the 3.8% net investment income tax makes it 23.8%. State taxes can be substantial — as high as 13.3% in California. They are deductible against the federal tax, but they are an itemized deduction. After the itemized deduction phase-out and the alternative minimum tax, you may not really get much — if any — benefit. So let’s simplify and assume the combined federal-state tax rate is 30%. Say you paid $100,000 for your $350,000 Porsche Speedster. That $250,000 gain costs you $75,000 of tax, leaving you $275,000 in cash. That is a roughly 20% loss of value. For the sell-and-buy-back-cheaper strategy to work, Speedster values have to go down by more than that 20% for you to come out ahead. Plus, while you wait for that to happen, you don’t have a Speedster to drive. Plus again, you have to believe you will later find another one just as good as the one you sold, which isn’t always very easy to do. This is a good example of what any stockbroker will advise you — you’re just fooling yourself if you think you can time the market. Unless you are willing to part with your cars forever, selling them now may not make the most sense.

Minimizing state taxes

If you decide to sell your collector car, the 20% federal capital gains rate is the best deal you are ever going to get. But many collectors are taking aim at their state income taxes, which can be quite high. During the past few years, favorable IRS rulings have popularized a tool called an ING Trust, or an Incomplete Non-Grantor Trust. Here’s how this works: You start by creating an ING Trust in a state that does not tax trusts. If you choose Delaware, you have a DING Trust. Nevada gives you a NING Trust, South Dakota an SDING Trust, and Wyoming a WING Trust. The ING Trust is designed so that gifts made to the trust are “incomplete” for gift and estate tax purposes. This means that you do not have a taxable gift and the ING Trust is still included in your estate. It is designed to not be a grantor trust, meaning that its undistributed income is taxed to the trust. To accomplish all that, you have to have a professional trustee in the state of formation. The trustee can, but is not required to, make distributions to you or members of your family. Once the ING Trust is formed, you transfer your collector car to the trust. Better yet, you can first transfer the car to an LLC of which you are the manager, and then transfer the ownership of the LLC to the ING Trust. That way you, not the trustee, drive the car. After some time, the ING Trust sells the car. The capital gain is taxed to the ING Trust, but its federal tax rate is the same as yours. The advantage is there is no state tax because the ING Trust is formed in a no-trust-tax state. The after-tax proceeds are then invested, and distributions are made to you and/or your family under the terms of the trust. The only hitch is that the ING trust has to be designed so that it is not taxed in your state of residence. In most cases, that is accomplished by making distributions to you permissive but not a mandatory. You encounter some administration expenses in creating the ING Trust and compensating the trustee, so you have to have some significant state income tax savings to make the technique worthwhile.

Deferring tax to next year

Say you want to sell your car today but want to defer the tax until next year. Perhaps you think tax rates will be lower after the election. Or you are planning to move from a high-tax state to a no-tax state before the end of the year. One simple approach is to sell the car on an installment sale contract, where you pay tax as you receive the payments on the sale price. The buyer makes a down payment today and pays the remainder of the sales price next year. You recognize gain on the down payment this year, but the rest is deferred until next year. The difficulty with this approach is being comfortable with the buyer’s ability to pay. A large enough down payment can help cushion the downside, but that increases the tax this year. To make matters worse, the tax law is not very favorable to you if the sale fails. If you have to take the car back, you are still taxed as though you received cash equal to the value of the car. The unsatisfactory equalizer is that, when you later resell the car, you don’t get taxed on the same gain again. An alternative would be to take a large non-refundable deposit, or an option payment, this year, with the actual sale taking place next year. Since the sale occurs next year, no tax is due until then. If the buyer fails to pay, you keep the option payment or deposit. Obviously, you need a pretty large payment to give you comfort that the sale will actually happen. Generally speaking, the larger the initial payment, the easier it is for the IRS to claim that the sale was made this year.

Monetized Installment Sale

Several companies are marketing what they call Monetized Installment Sales. You sell your car to them — let’s call them the Monetizer — on a 30-year, interest-only installment sale. The Monetizer immediately sells the car to your pre-arranged buyer for cash. The Monetizer arranges for a third-party lender to lend you a “high percentage” of the sales price, repayable over the same 30-year term on an interest-only basis. So far, the Monetizer owes you the entire sales price, but you have most of the cash from the loan. The monthly payments made by the Monetizer are sufficient to cover your payments to the lender. At the end of the 30 years, the Monetizer pays you off, you pay off the lender, and you owe all of the tax to the IRS. This works well on paper, but there are several ways it can go wrong. If the Monetizer goes broke, you may never see the sales price but you may still have to repay the borrowed money to the lender. If an IRS audit determines that you owe all your tax now, it is not apparent that you have any right to force the Monetizer to pay you off early. This technique is based upon a favorable IRS ruling that involved an installment seller who later borrowed money from a lender and pledged the buyer’s note as collateral. The ruling did not involve an intermediary Monetizer, so we don’t know if that would make a difference in the tax treatment. Most importantly, 30 years is a long time for us Baby Boomers. We may well have trouble outliving the deal. Same goes for the people running the Monetizers. If this appeals to you, you will need to have in-depth legal advice before getting into the transaction. ♦ 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.