As every Baby-Boomer knows, time is no longer our friend
As the baby-boomers leave the market, many long-term-ownership collector cars are coming to the market. Some are sold because they sat unused for years, some are sold to pay off homes, get cash back for other projects, settle estate complications 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.
How it all began
Introduced with the revenue act of 1921, 1031 trades were originally used primarily in the real-estate world by neighboring farmers who would exchange one parcel of land for another for such purposes as straightening out property lines. Over the decades, the use of the provision broadened widely, thanks to rulings by the Treasury Department and Internal Revenue Service.
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 to today’s 20%. He also added in a 3.8% Medicare (Affordable Care Act) 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.
The 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.
Capital costs such as major repairs, restoration, mechanical rebuilds, a new interior and more are included. The cost of taking your car to multiple shows can be deducted as the shows were meant to increase your car’s marketability and credibility, but normal wear-and-tear items such as oil changes and tune ups can’t be deducted unless they were in preparation for a show or event. The paperwork trail and job descriptions are all important! No paperwork, no deductions.
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 Lusso fifteen years ago for $250k. After multiple cost and time overruns, the restoration was finally completed 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. You missed the peak of the market in 2014, but you’ve found a buyer for $1.6m for a $1m profit taxable at 23.8% Federal plus your state’s 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 approximately $371k will go to your silent partners, the I.R.S. and Jerry Brown.
You can’t avoid, but you can defer, paying that tax by using a 1031 Like-Kind Exchange, it’s all in the paperwork. You’ve chosen your Qualified Intermediary, you have your buyer in place, the sales agreement states the transfer will go through your Qualified Intermediary in a 1031 Like-Kind exchange and your Qualified Intermediary writes up the appropriate paperwork and has it signed by you and your buyer before any money changes hands. Once done, your buyer sends the total $1.6m to your accommodator and your 250 Lusso is now his.
Meanwhile, you’ve located a 599 GTB at $150k, a great Daytona at $600k and a nice driver 2-headlight 330 at $250k. 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.
It’s all in the math
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 cars 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 Lusso for an industrial building or the Cessna CJ-1 jet of your dreams. All cars must be for investment purposes, your 599 GTB, Daytona and driver 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.!
The party may be ending
Adding to the pressure, the Obama administration had recommended a $1 million annual gain limit and the exclusion of the collectible asset classes, but like many Obama projects, it was thankfully never passed. Perhaps you thought Trump would be more tax and business friendly? Trump’s proposed tax plan, called the “Better Way”, may cut taxes, but makes it up, in part, by elimination of 1031 like-kind exchanges, with no offsetting provision, as part of a broad federal tax overhaul. With a Federal debt of 20 Trillion, millions of aging baby boomers, ever climbing medical costs and under-funded federal, state and union pension plans, taxes will only go up. 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 market boom began in late 2010 so we’re in year seven of today’s boom. Timing is everything, a run of bad days at the Fed, the Dow or in the bond market can render the best laid plans worthless. Buyers and sellers follow the herd mentality, there’s no lack of buyers on the way up and there are all-too-few buyers on the way down. If the 1031 tax code is soon to be eliminated, it’s better to sell early rather than too late. As any market trader knows, the trend is your friend, until it ends.
Feel free to drop us an e-mail if you have any questions on how a 1031 tax trade might work for you.