The 2014 Scottsdale auctions showed that many collectors are taking advantage of the hot market and selling cars for record prices. But many of those collectors are also learning that we are in an era of high income tax rates.
So, how can collectors minimize the tax costs?
Basic tax principles
Let’s start with some basic principles. The gain on the sale of your collector car is the difference between your net sales price and your income tax basis.
Your net sales price is the gross amount received, less your selling expenses. In an auction setting, the selling expenses can be substantial and include:
- All fees paid to the auction company, including your entry fee, the
- seller’s commission, any incidental expenses charged to you and so on
- Costs to transport the car to the auction
- Your airfare, lodging, meals and other travel expenses to from and during the auction, as your presence at the auction is important to the result. You can also count your spouse’s expenses if she is a co-owner of the car and participates in the effort
- Compensation and travel expenses of your employees and agents who assist in the process
- Your income tax basis is essentially the record of your investment in the car. It starts with your purchase price and can include:
- Pre-purchase inspection expenses, including travel expenses for you, your employees and agents
- Costs to transport the car to your home or storage facility
- Costs incurred to make the car ready for its first use, such as repairs, restoration, paint, etc.
- Cost of improvements made to the car during your ownership, but with two limitations: (a) Ordinary repairs (oil changes, tune-ups, brake jobs, fixing broken parts) don’t count. Only major improvements (such as engine rebuilds and restorations) can be counted. (b) You can’t count repetitive improvements. For example, if you rebuild the engine twice over the life of the car, you only count the second rebuild
- Costs incurred immediately before the sale for the purpose of making the car ready for sale — here, there is more leeway to count repairs, detailing and so on
Tax rates are key
Your collector car should qualify as a capital asset, meaning that your gain is taxed as a capital gain. This is favorable if it is a long-term capital gain — you owned the car for at least one year when you sold it. But that can still lead to overall rates as high as 37.1%. This is how it works:
1. The maximum federal rate is now 20%. (The 28% rate for collectibles does not apply because cars are not defined as “collectibles” under the tax law.)
2. Add another 3.8% for the new tax on net investment income, often referred to as the Medicare tax. This applies if your adjusted gross income is at least $200,000 ($250,000 on a joint return). The first catch is that the gain on the sale of your collector car counts toward this threshold, and can be enough by itself to put you over. The second is that, once you exceed the threshold, all of your net investment income is subject to the 3.8% tax.
3. State income taxes vary by state, with a high of 13.3% in California. Some — but not all — lower their rates on capital gains.
4. Your state income taxes are deductible on your federal return, but the alternative minimum tax and itemized deduction phase-outs make it questionable how much, if any, benefit you will actually receive.
Add all that up and you can get a 37.1% combined rate.
Things get worse if you owned the car for less than a year. That makes it a short-term capital gain, which is taxed as ordinary income at a maximum federal rate of 39.6%. Points 2, 3 and 4 stay the same however, so your combined rate can be as high as 56.7%.
Like-kind exchanges
No surprise here — income tax rates send many collectors looking for ways around the tax. Unfortunately, there is no way to avoid the tax. But you can defer it if you use a like-kind exchange to reinvest the sales proceeds in one or more other collector cars.
Let’s take a simple example. You are selling your Ferrari Daytona for $450,000. You bought it long ago for $150,000, so you have a $300,000 long-term capital gain on the sale. At the 37.1% maximum combined tax rate, that will cost you $111,300 in tax, leaving you only $338,700 with which to buy another car.
You can avoid paying that tax by using a Like-Kind Exchange (also known as a 1031 Exchange). To do that, you have to engage the services of an accommodator. In its simplest form, the process works like this:
First, you find a buyer for your Daytona and enter into an appropriate sale agreement, which contains a provision allowing you to convert the transaction into a like-kind exchange.
Next, before completing the sale, you enter into an exchange agreement with the accommodator, assign your sale agreement to the accommodator, and inform the buyer of the change.
Now, the sale is completed, with the buyer paying the $450,000 sale price to the accommodator and you transferring the title and releasing the Daytona directly to the buyer.
Next, you locate a replacement collector car, and enter into a purchase agreement with the seller.
Finally, you assign the purchase agreement to the accommodator, who pays the $450,000 to the seller. The seller transfers the title and releases the replacement car directly to you.
End result — no gain is recognized, and no tax is payable. Your basis in the replacement collector car is the $150,000 basis from the Daytona, transferred over. If you later sell the replacement car for $450,000, you recognize the same $300,000 gain. Thus, the gain is deferred, not avoided.
Devilish details
There are two very strict deadlines to be aware of, with no extensions allowed:
- You are allowed a maximum of 45 days from the day that you transfer the Daytona to identify potential replacement cars. They must be specific cars — not just marques or models. Once the 45 days pass, you cannot identify additional potential replacement cars.
- The purchase of one or more of the cars you identified must be completed within 180 days from the day that you transfer the Daytona.
Of course, you can do everything within the 45 days. However, the 180-day limit can be useful when work needs to be done on the replacement car before you purchase it. The trick is that, for the work done on the replacement car to be considered part of the exchange, the work must be done by the seller or the accommodator before the 180 days run out — and before the car is transferred to you. You can’t count the cost of work done by you or after the deadline.
Timing can be very quick in an auction setting. The accommodator must become involved before the sale is made. That should be the day the auction company releases the car and the title, but the IRS could view it as the day the hammer falls. Give the auction company early notice of your plan.
The numbers don’t often work out perfectly. If the replacement car costs more than $450,000, you can add in the difference. Your basis in the replacement car then becomes $150,000 plus the additional money you paid. If the replacement car costs less than $450,000, you can take the remaining money, but it is taxable.
You can reinvest in more than one car. You can identify up to three replacement cars, more than three if you meet some technical requirements. However, the only cars that are eligible for purchase are the ones that you identified within the 45 days.
The accommodator must be a “Qualified Intermediary” under the tax law. It must be independent of you, and cannot be your attorney or accountant or a close relative.
Tax-free exchanges are available only where the properties are of a “like kind.” Cars are all treated as being like-kind, but you can’t trade your collector car for real estate. Also, both cars must be held for investment purposes. You can’t exchange into a new Porsche 911 that you will use as your daily driver. And you can’t do this at all if you are a dealer.
Strategies
If you are planning to maintain your investment in collector cars, like-kind exchanges can be a very potent planning weapon. You can defer the gain indefinitely. And, at your death, your collector cars pass to your heirs with a full basis step-up to their fair market values, so the deferred gain is then washed away.
If you think the collector-car market is peaking, and you want to cash out, there is no way to get out of paying the tax. That puts you on the horns of a pretty tough dilemma. You can cash out and avoid the perceived market risk, but you have to pay up to 37.1% of your profit in tax. Or, you can avoid that tax by staying invested in collector cars, but then you are subject to the market risk.
Better polish off that crystal ball. ♦
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.