The IRS can't tax you after you're gone, so they tax you on the way out





Last month, Publisher Martin made some insightful observations about the current state of the collector car market and how collectors should act in (September, "Time to Buy, Sell or Hold?" p. 10). I won't question Keith's views of the market, as I've developed great respect for them since he and I actually made money on Lucky, our 2-stroke Saab. But I will add that the many layers of taxation that affect this decision play a pretty big role in your final decision.

Take John's Ferrari



Let's take my friend John as an example. He acquired a wonderful 1966 Ferrari 365 California Spyder back in the '70s at the then market-correct price of $25,000. Today, let's call its market value $1 million, although he could probably get more for it given how values are skyrocketing. John has enjoyed the car for many years, but he doesn't drive it as often as he used to, and it's getting time to downsize his collection. Further, while he is fortunate not to need the money, he sees the future of the collector car market as uncertain. He wonders what would be the best investment decision here. That is, should he take the money and run? Hold the car and let his family inherit it? Give it away?

Capital gains taxes



If John sold the Spyder, his $975,000 profit would be taxed as a long term capital gain. That is a good deal, because capital gains are currently enjoying their lowest ever rates of tax. However, the rate is not the 15% most would expect it to be. That is the tax rate for capital gains with respect to stocks, real estate, and most everything else. But collector cars are treated as collectibles (along with art, jewelry, antiques, rugs, and other tangible personal property), and the tax rate is 28%, or $273,000 to the IRS.

But the IRS is not the only tax collector with its hand out. Your state probably expects to receive a share of your profit as well, unless you live in one of the few states that do not have an income tax. The tax rates vary considerably from state to state, with an apparent low of 3% in Illinois and an apparent high of 9.3% in California. That adds another $29,250 to $90,675 to John's income tax bill. Of course, the state income tax is deductible on your federal return, but it is treated as an itemized deduction. After jumping through the hoops of the itemized deduction limitations and the alternative minimum tax, you might not really see much benefit at all. So let's say the average net state tax cost is 6%, or $58,500, making the total tax bill $331,500. That leaves John with $668,500 in his bank account.

That calculation will surely sober you up (or drive you to drink), but will waiting make it better? Waiting to sell defers the tax for sure, but we don't know what the tax rate is going to be later. The current ultra-low capital gain rates are set to expire in 2011, and they may well go up then, especially depending upon which party controls the government after the next election. But collectibles are already taxed at 28%, so their rate might not change as much.

Estate tax uncertainties



The IRS can't tax you after you're gone, so they tax you on the way out. The estate tax applies to the full fair market value of everything you own at your death, less your debts. Under present law, most collectors are probably in the 46% bracket. That produces a federal estate tax of $460,000, but there are a lot of changes upcoming to keep in mind.

Under present law, each of us is allowed a $2 million exemption against our estate tax, which increases to $3.5 million in 2009. In a political coup de grace, the estate tax is repealed altogether in 2010. But it returns in 2011 with a reduced exemption of $1 million and even higher tax rates.

Very few estate tax professionals believe that the scheduled 2010 and 2011 events will really occur. However, Congress is not doing anything to change that. One reason is that we don't know which party will control the government after 2008, and both parties want to wait and see. Another is that both parties have learned that the need for change has triggered huge amounts of political contributions to both parties, and neither wants to stop that cash inflow any sooner than necessary. Nonetheless, the prevailing view among tax professionals is that we will see a law change in 2009, which will preserve the estate tax and establish exemptions in the $3m-$4 million range. Maybe.

Once again, the states are looking for their share as well. Not all impose inheritance taxes, but about a third do, with typical rates in the 6%-8% range. Let's say that's 7%, or another $70,000, bringing the total estate tax bill to $530,000.

Income tax connection



The estate and income taxes are connected in a very important way. Once your collector car passes through your estate, your family inherits it with a new "stepped up" basis equal to its market value. That is, once the Ferrari is exposed to estate tax at its $1 million value, whether or not any tax is actually paid, the family gets a $1 million income tax basis and can sell it at that value without any income tax. But if the estate tax really does go away in 2010, so will the stepped-up basis rule, and John's family will inherit the Ferrari with the same $25,000 income tax basis.

Comparison



It is impossible to know what the law is going to end up being, so let's compare the overall income and estate tax results under current law. The alternatives are to sell the Spyder and let your family inherit the proceeds, or to hold the Spyder until your death and let your family sell it.

Give it to the kids



Giving the car to his children probably doesn't work very well for John. The gift will use up $1 million of his exemption, so it's initially estate tax neutral. The benefit is that the future appreciation in the car accrues to the benefit of the children, and skips John's estate altogether. However, the price tag is that John's children take the Ferrari with his same $25,000 basis-it didn't go through his estate so it didn't get a stepped-up basis. Consequently, they assume the $331,500 current income tax burden, and John's estate tax exemption is partially wasted on the portion of the value that will ultimately go to the IRS in income tax.

Give it to charity



Giving the car to a charity could be an attractive option. For certain, the Ferrari will be removed from John's estate and reduce his estate tax bill by $530,000. In addition, John becomes entitled to an income tax deduction for the charitable gift, which can save him even more.

The amount of the income tax deduction depends on what the charity does with the car. If the charity immediately sells the car, John's deduction is limited to his $25,000 basis. But if the charity uses the car in furtherance of its charitable purpose (say, it's a non-profit museum created by John or someone else and it puts the Ferrari in its permanent collection), John gets an income tax deduction for the full $1 million value of the Ferrari. That could be worth as much as $450,000, depending on one's individual circumstances and place of residence, although saving $450,000 of income tax could increase one's estate tax by $238,500.

Some conclusions



Avoiding capital gains tax by holding the Ferrari until death produces substantial savings under current law, but there are two very substantial risks here-not knowing what the tax law is going to be, and not knowing what the collector car market is going to do.

The income tax rules are now probably as good as they are ever going to be. The estate tax rules either are, or soon will be, as good as they are ever going to get. The unpredictable factor is how long they will stay that way. If taxes play a big role in your decision, and the current rules work for you, the next couple of years would be a pretty good time to act.

If holding the car until your death is the most appealing option, bear in mind that if the income tax rules get tougher, you might end up in an irreversible long-term hold strategy. And remember that the collector car market has its cycles, and they can be fairly long ones. John's California Spyder has been a very strong financial performer, but it lost a lot of its value in the early 1990s, and it took nearly two decades to recover.

Bottom line, if you've reached the point that you don't really use the car any more or you don't get the same enjoyment out of just owning it, it's probably a good time to let it move on. An adverse tax change can easily outweigh the last bit of market appreciation.

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