We are addressing provenance created by the owner after a car's acquisition, and whether the costs involved can be used to reduce the gain on the sale
Many collectors are selling cars they have owned for several years, often for substantially more money than they paid for them. In many cases, they purchased these cars years ago when they weren't particularly sought after or valuable, usually because they just liked the cars and wanted to own and use them. Now that the market has made them into very valuable assets, they are cashing in on their investments and finding that the IRS is there, open hand stretched out, asking for its share.
"Legal Files" has explained before that your profit on a collector car is taxable as a long-term capital gain (assuming your use qualifies), and that the appropriate federal tax rate is 15%. The amount taxed is the sales price net of selling expenses, less your "basis" in the car. Your basis is essentially your investment in the car, which is your cost plus the cost of improvements you made to the car.
But it isn't always that simple. A collector doesn't just buy a car and park it in the garage, like a stock certificate sitting in a safe. A portion of the value of the car is created by activities in which the collector used the car-activities that added to its provenance. These can include winning Best of Show at Pebble Beach or Amelia Island, showing it at prestigious European events, successfully running the Mille Miglia without a breakdown, or racing it in the Monterey Historics, the Historic Le Mans, or the Historic Monte Carlo Rally. All of these events added to the provenance of the car and enhanced its value and, ergo, its ultimate sale price. But can these costs add to the basis of the car and reduce the amount of the collector's taxable gain?
Let's define provenance
A car's provenance is comprised of two parts-its history and the significance of the elements of that history. It starts with establishing the precise identity of the car-its authenticity as the specific automobile it is represented to be, as well as its original configuration. That goes hand in hand with establishing the complete ownership history of the car, from owner to owner.
The final element is establishing the specific events and activities in which the car participated that make it special; for example, its racing history in prestigious events with prestigious drivers, concours wins, famous owners, etc. You name it-anything of significance that separates this particular vehicle from other, similar examples, making it a "piece of history." Establishing the car's provenance may require extensive research: searching through marque club records and registries, vehicle registrations, SCM auction trails, period publications, even Googling prior owners to locate and interview them. It's easy to see how much effort this can require.
The tax law is muddy
All of these elements of the car's provenance increase its value and are built into the car's initial purchase price. But what we are addressing here are the portions of the car's provenance that are created by the owner after its acquisition, and whether their cost can be treated as part of the basis of the car. Our firm recently had the assignment of researching these issues for a collector with a substantial gain on the sale of his car.
Surprisingly, our extensive legal research could not uncover any statute, regulation, ruling or case that directly considered the tax character of these expenditures, or anything even close. But by applying general rules governing the deduction and capitalization of expenditures, we determined there are three possible tax characterizations for these expenditures-deductible expenses, personal expenditures which would yield no income tax benefit, and capital expenditures which add to basis.
1. Deductible Expenses
These expenditures could have been deducted as incurred if they were part of a business or profit-seeking activity, but that isn't very likely for the collector. There is some legal authority that appreciation can serve as the "profit" element here, but it's still pretty tenuous for the typical collector.
2. Personal Expenses
The IRS could certainly claim these expenditures are just personal expenses, since the collector personally participates in these events. However, there is ample legal authority (very prominently in many auto racing cases, for example) that an otherwise deductible expenditure does not lose its character simply because the taxpayer receives personal enjoyment from the activity.
3. Capital Expenditures
Under general tax principles, expenditures must be capitalized (added to basis instead of being deducted) if they constitute a betterment of an asset-traditionally, adding over a year to the useful life of the asset. The rules on this changed somewhat with the Supreme Court decision in the INDOPCO case, which took a more general view and required expenses to be capitalized if they provided benefits for the indefinite future. The IRS has responded with new regulations.
One provision says that expenditures must be capitalized if they create an intangible asset. None of the examples given in the regulations address the provenance of a collector car, but it should be reasonable to view the provenance of a collector car as an intangible asset. As collectors, we all know that provenance is an elusive intangible asset that has a very real effect upon the collectible nature of a car, and its resulting value. For example, all Porsche 962s are collectible, but the most valuable ones are those with the best racing histories.
Clearly, the collector car market highly values the intangible characteristics of a given car, or its provenance. Without doubt, a collector's use of a given car can involve activities that add to its provenance, and to its value. It is logical that the costs incurred by the collector in creating that provenance should be capitalized on the basis that they have either created an intangible asset, or that they are betterments within the meaning of INDOPCO. Either way, the expenditures would add to the basis in the collector's car and reduce the taxable gain upon its sale.
Drawing the line
Although our research indicated that collectors can make a strong case that expenditures that add to the provenance of a collector car can be added to its basis, not every single dollar spent on the car can qualify. It is important to be reasonable about identifying the expenditures that actually create provenance. Being greedy here can leave you in an untenable position, and the IRS and the Tax Court judge may well treat all the expenditures as personal expenses.
Only events and activities that add to the car's resume in a meaningful way should even be considered. When the events fit the mold, the amounts that can be counted include the full cost-entry fees, support services, transport, and your own travel, meals, and lodging. Expenses for spouses, family, friends, etc. are highly suspect. Further, travel expenses are subject to specific limitations, especially foreign travel, which space does not allow us to address here.
Building your case
It is important to have an appraisal that documents not only that your efforts added to the provenance of the car, but also that the provenance added to the sale price. Ideally, the appraisal would show your car sold for a specific amount greater than it would have without the provenance you created. The difference should be substantial to stand a chance of being respected, but it shouldn't necessarily have to be greater than the amount you spent.
Also, you would be well advised to get a formal tax opinion from your tax attorney or CPA supporting this position. If the IRS audits your return, the tax opinion might deter the auditor from challenging you. And if there is a challenge and you can't sustain the position, or decide it isn't worth the fight, the tax opinion should protect you from additional penalties.