Collectable Ferraris, 1031 Tax Trades* & the I.R.S.
The I.R.S. and State are not your friends, will try to re-negotiate the terms of your unwanted “partnership” and will use any paperwork errors to punish you severely.
Online Exclusive—June 2014 issue
by Michael Sheehan
Let the good times roll
The 10 May RM Auction in Monaco again raised the price bar to all new price levels with RM selling over 41.m €uro ($56m) in total with a 93% “close ratio”! The highest price paid was for 275 GTB/C s/n 9067 sold at 5,712m €uro ($7.8m). The long-term numbers tell the story as s/n 9067 was purchased by its long term owner in 1995 for 600k. A sister car, 275 GTB/C s/n 9027 clearly shows the market run-up, selling for 915k €uro ($1.1m) at Bonham’s on 15 May 2004 then sold again for £1,6m ($2.3m) on 09 Sept., 2013 at RM’s London auction. RM Auctions’ sale of 9067 represents a tripling of 275 GTB/C prices in a single year and a thirteen times multiple over twenty years.
Equally as impressive was the sale of 330 GTS s/n 10719 for a staggering 2.1m €uro ($2.9m), another massive price-point run-up. The very same 330 GTS s/n 10719 was offered in the Ferrari Market Letter in 2002 for a modest $198k and again offered in Europe in 2005 for $300k USD before selling only last year at RM’s Don Davis auction in Texas for what was a then-shocking $1.9m! RM’s sale of s/n 10719 represents a 50% increase in a single year and a ten times multiple over ten years.
Needless to say most of the current collector car market run-up has been fueled by quantitative easing, often less-kindly referred to as money printing. Thank you Ben Bernanke! With most official government inflation figures in the 2% annual range or less and collector car inflation at obviously much higher rates, collector cars have been a fun place to park cheap money. One only needs the banking connections to play the game. Needless to say this cheap-money fueled party will slow down when the printing presses stop, but to date only Janet Yellen at the Fed and Mark Carney at the Bank of England have clearly stated the presses will stop anytime soon.
What could possibly go wrong?
The post 2008-socio-economic good news is that the Euro-zone hasn’t imploded, Greece, Italy, Portugal and/or Cyprus haven’t left the Euro. The Irish have proven that austerity and an export-driven workforce [that actually pays their taxes] can turn the economy around. Japan manages to keep the printing presses rolling at full speed and US real estate is staging a modest comeback, yet another hedge fund leverage opportunity. Additionally the trillion dollar wars in the Middle-East are being wound down and un-employment in the US is slowly, painfully improving.
The bad news is that Mario Draghi, head of the European Central Bank, has become Mr. “Whatever it takes” and has vowed to print endless Euros to end the Euro-zone’s recession. Obama opines that the US “Doesn’t have a spending problem”, pushing US Federal debt to all new heights while Shinzo Abe, the Prime Minister of Japan, has no options except to keep the Bank of Japan printing presses on overdrive. All three leaders advocate that targeting a healthy level of inflation will energize exports, revive production, spur profit, expand employment, raise wages and drive up tax revenue in a perfect cycle of growth. Obviously Draghi and Abe’s money-printing plans are a contradiction to the Fed’s Bernanke-Yellen “tapering”, but who’s right, the Bernanke-Yellen “taper” or the Abe printing presses? Only time will tell in what is clearly a wild bubble market.
Taking profit off the table
In a perfect world there are always buyers and always sellers. Today’s sellers are those who bought years ago and for whatever reasons, be that a nice profit, a decision to put money elsewhere, a chance to get cash back for other projects, or the ever-present fear of today’s bubble bursting. Unfortunately for Americans, profits on investment/collector cars are taxable at both a Federal and State tax level. The I.R.S. and the State in which you live have been your “silent partners”. The good news is that through a 1031 tax trade much of the painful tax bite can be deferred down the road.
Collector cars are now a recognized asset class so your collector car should qualify as a capital asset. You did buy it as “an investment”, taxed at 20% and not as “a collectable”, taxed at 28%, right. You’ve owned it for over a year so any profit is taxed as a long term capital gain. On the Federal level, the bad news is that Obama (the collector car Grinch) raised long term capital gains from 2012’s 15% to today’s 20%. He’s also added in a 3.8% Medicare (Obamacare) tax if your adjusted gross income is at least $200k (or $250k on a joint return). And yes, the gain on the sale of your collector car is added to your total income. F.W.I.W. once you exceed an adjusted gross income of $200k all of your net investment income is taxed at that additional 3.8%. Adding to the pain, your other silent partner, the State in which you live, has their own tax rates. California will get you for 13.3% while a few more tax-friendly states such as Florida and Texas have zero state Capital gains tax. If you’ve owned your car for less than a year it’s a short-term capital gain, taxed as ordinary income.
Basics of 1031 tax trades
The bad news is that, long term, there is no way to avoid the tax, except death! And even in death there are estate taxes, but that is a subject for another day! The good news is that through a 1031 trade, taxes can be kicked down the road to be dealt with another day, a solution all politicians seem to have perfected. This can only be done through a Qualified Intermediary. More on that to follow.
If you chose to sell through an auction you will pay a seller’s premium, in the 5% - 10% range. Additionally there will be a buyer’s fee, usually in the 10%-12% range. These reduce the amount you actually receive, pre-tax by 15% - 22%. Your costs to prepare your car for auction and any cost of employees or your spouse at the auction can also be deducted. The Qualified Intermediary must be involved before the auction sale or your silent partner at the IRS could view the “sale” as the day the hammer falls, which starts the clock ticking.
Should you choose to use an established broker, the fee will be in the 5% range and you will have more flexibility on the escrow “close date” and paperwork processing. In both cases you can also deduct capital costs such as major repairs, restoration, mechanical rebuilds, a new interior, etc. If your car has been to multiple shows the associated costs can be deducted as the shows were meant to increase your car’s marketability and credibility, but you usually cannot deduct normal wear-and-tear items such as oil changes, tune ups, etc, unless they were in preparation for a show or event. The paperwork trail and job descriptions are all important! No paperwork, no deductions. Yet another subject to discuss with your professional.
The Do’s and Don’ts
DO NOT try doing a 1031 Exchange using your CPA or attorney to hold title or funds. The IRS requires a Qualified Intermediary and disqualifies any attorney, broker or accountant routinely used by the taxpayer. DO NOT take any payment before or outside your Qualified Intermediary or you void the exchange. Once started you have 45-days to identify your trades and 180-days to exchange deadlines, so having your buyer and trades lined up is very important. DO NOT miss these deadlines. DO NOT change the title during the exchange and DO NOT file your income taxes for the year in which you do your exchange until you complete your exchange. DO NOT “close” your 1031 tax trade until ALL paperwork is signed and approved by your Qualified Intermediary. The I.R.S. and State are not your friends, will try to re-negotiate the terms of your unwanted “partnership” and will use any paperwork errors to punish you severely.
DO try to have the “sell” and your “buys” lined up and any pre-purchase inspections done before you open a 1031 trade. DO identify extra possible trades as trades do not always work out. It doesn’t cost anything to identify other possible trades. DO reinvest all exchange proceeds as you pay tax on any-and-all proceeds not reinvested. DO get a written opinion from your tax professional as a written legal opinion should offset any penalties (but not late fees) should the I.R.S. challenge your 1031 tax trade. Do be prepared to prove in an audit that your “old” exchanged vehicle was neither inventory nor personal use property.
How does it work for you?
Perhaps you were able to buy a project 250 PF Cab ten years ago for $250k. After multiple cost and time overruns the restoration was finally competed at a cost of $250k. You then had it trucked to Concorso Italiano, the FCA Nationals and Cavallino multiple times. You bought books and tools and multiple small bits. You had it back in the shop for additional work to get those extra few points and you’re ready to sell. Fortunately you have copies of every invoice and every canceled check for entry, trucking, hotels, restaurants, detailer and support staff to document your costs. Let’s say that your well documented total investment is $600k and you’ve found a buyer for $1.6m for a $1m profit taxable at 23.8% Federal plus your states taxes. You’re in California so your total tax rate is an extra 13.3% for a total of 37.1% of your $1m profit and so app $371k will go to your silent partners, the I.R.S. and Jerry Brown.
Meanwhile you’ve located a 550 Barchetta at $200k, a great Daytona at $700k and a very ratty 4-headlight 330 at $100k. Your Qualified Intermediary writes up the appropriate purchase agreements, has them signed by you and the sellers and they are paid for and on their way to you. $600k is left with the Qualified Intermediary and after 45 days (and more paperwork) it can be returned to you. In a perfect world the $600,000 back to you is merely the return of your original investment and so should be tax free but that’s not how the I.R.S. interprets the rules. As per the I.R.S. your profit is $1,000,000 and so the $600,000 back to you (known as “boot”) is fully taxable. The ONLY way to defer taxes is to take all cars, no cash. Furthermore each of the 1031 trades will be taxed at 37.1% when they are sold, but perhaps you will have moved to State-tax-free Texas or Florida before it’s time to sell. If you need to pull out cash it’s best to wait until your 1031 is done and then refinance your new addition or additions.
DO NOT try this at home, DO NOT try this if your car is dealer inventory or a personal use/pleasure auto.
The math doesn’t always fall so easily into place. In our example you’ve identified three replacement cars, but more than three cars can involve technical requirements. If your 1031 trade car or cars costs more than $1.6m, you can add in the difference. Your basis in these car then becomes your $600k plus any extra money you paid, reduced by the amount of cash you received, and increased by the amount of taxable gain which you recognized. Got that? 1031 tax trades are “like kind” so you can’t trade your hypothetical 250 PF Cab for an industrial building or the Cessna CJ-1 jet of your dreams. All cars must be for investment purposes, your 550 Barchetta and ratty 330 2+2 are investments and will go up in value, correct? The good news is that if you want to hold your trades forever your investment cars pass to your heirs at your death with a full basis step-up to their fair market values, so the deferred gain is then washed away up to your estate’s exemption limits. Only in death is there any hope of escape from the I.R.S.!
If you think the collector-car market is peaking and you want to cash out in full there is no way to get out of paying the tax. You will pay up to 37.1% of your profit in tax.
The follow-the-herd mentality
We are NOT tax lawyers or tax accountants, this column is NOT meant as legal or tax advice, merely our observations after forty-plus years in the business. That experience tells us that economic booms or bubbles tend to follow three-to-five year “down” cycles and five-to-seven year “up” cycles. Our most recent Ferrari boom began in late 2010 so we’re in year five of today’s boom. Timing is everything, a bad day at the Fed or in the bond market can render the best laid plans worthless. Had you bought a Daytona coupe at the height of the 1989 boom years ago and paid the-then market price of $500k, this car has represented dead money until very recently, not to mention storage, repairs, insurance, etc. Having lived through four previous Ferrari price bubble “pops” in 1979, again in 1990, again in 2000-2001 and the last one in 2008, I long ago learned that bubbles tend to pop, not deflate slowly. Buyers and sellers follow the herd mentality, everyone wants to be a buyer on the way up and there are all-too-few buyers on the way down. As always, the trend is your friend, until it ends.
Feel free to drop us an e-mail at Mike@Ferraris-online.com if you have any questions on how a 1031 tax trade might work for you.