Maybe you already own a 1962 Corvette and a 1968 Camaro but your buddies at Cars and Coffee have been telling you that more modern muscle cars are the way to go. They are safe, faster, and sound just as cool. Plus, you recently watched a Mecum Auction marathon on NBCSN and attended a Barrett Jackson event and this has caused you to consider adding to your car collection. Maybe you are looking at a new 2016 Dodge Viper ACR, a new Corvette Z06, or perhaps something European to go into your collection. The good news is that now, more than any other time it is a great time to be a car gal or guy. The selection of modern performance cars, the volume of restored classics and muscle cars, along with the popularity of collector car auctions has generated a buzz like never before.
Here comes the Tax Man!!
But what if you need to liquidate one of your current cars to make the new purchase a reality? Additionally, like with all other investments, taxes could have a negative effect on the overall financial result of the transaction. Net capital gains from selling a car are taxed at ordinary income tax rates Federally. But, vintage, classic, and exotic cars that are owned as investments or are used in a trade or business are eligible for tax deferral through a 1031 exchange.
What is a 1031 exchange?
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and henceforth defer any capital gains taxes then due. Property used for personal use and enjoyment are not eligible for 1031 exchange tax deferral. A tax-deferred exchange under Section 1031 of the Internal Revenue Code will allow you to sell investment property or properties and acquire “like-kind” properties while deferring Federal, and possibly State, capital gains taxes. 1031 exchanges of vehicles are almost the same as doing 1031 exchanges for any other type of capital asset, including real estate. However, one important difference is that classic/exotic cars are only “like-kind” to other cars, and are not “like-kind” to other personal property or vehicle types such as motorcycles or boats. As with all deferred exchanges, an independent party who specializes in these transactions called a Qualified Intermediary (QI) is required to hold your funds between the sale of your relinquished car(s) and the purchase of your replacement car or cars.
How to use…
As an example, using a 1031 exchange, if someone bought a new 2005 Ford GT Heritage Addition new in 2005 for $150,000. They took a long term loan out for the car and currently owe $15,000. They have an offer from a qualified buyer in the amount of $445,000. Given all of this the net sales proceeds, not including sales commissions and expenses, would be $430,000. As the cost basis of the vehicle is $150,000 and if there was not a 1031 exchange completed, the IRS could be owed up to 39.6% in federal taxes if the person was in that tax bracket and could be owed an additional 3.8% net investment tax if their AGI is above $200,000.
Additionally, let’s assume that the person selling the car is a single unmarried doctor that has $320,000/year in taxable income before the sale of the car. This puts the doctor in the 33% income tax bracket. Adding the 3.8% NIT she is now looking at a 36.8% tax hit. Not good!!! Suddenly her “profit” from the sale of the car is reduced by $108,560 (($445,000 – $150,000) x .0368)! This would in essence reduce the proceeds available for reinvestment to $321,440.00.
So, if the doctor can qualify for, and then can complete a 1031 exchange, she will be able to defer the $108,560 federal tax and have the full $430,000 available for reinvestment for one or more replacement collector cars.
But isn’t a collectable taxed at a capped 28%? In some cases, yes but not in the case of cars. Federal law indicates that cars, whether personal use or not, are not treated as collectables for tax considerations.
Rules of the Road
There 6 basic rules to follow when doing a 1031 exchange. These rules are very important and you must plan for them ahead of attempting to perform the exchange.
- Qualified Use. Relinquished and replacement properties must both be held for investment or productive use in a trade or business only. These can’t be personal use vehicles. I do not recommend driving the cars at all if possible, not even to a car show. Have the vehicle transported. Another fact that is often overlooked is mileage at purchase. If the vehicle was purchased with 30,000 miles and then restored and still has about 30,000 miles on it then proving it is an investment is much easier than if it now has 50,000 miles on it.
- Holding Period. There is no specific time required to establish intended use for an investment. What’s important is that you treat the property as an investment and not hold it for resale or personal use.
- Equal Value. To defer all capital gain tax, replacement property must be of equal or greater value to the relinquished property. All proceeds from the sale of relinquished property must also be used in the purchase of the replacement property.
- Purchase Period. All replacement property must be identified within 45 days, and acquired within 180 days, of the sale of the relinquished property.
- Identification. You may identify the replacement property through three options: 1. 3 properties, no matter what their value; 2. any number of properties, with a combined market value that doesn’t exceed 200% of all relinquished property; 3. any number of properties, as long as you acquire 95% of the total value of the identified properties.
- Qualified Intermediary (QI). Also referred to as an Exchange Facilitator. A qualified intermediary must hold sale proceeds between the sale of the relinquished property and the purchase of the replacement property.
The process for completing the exchange can seem complicated at first which is why it is recommended that a team of experienced professionals guide the process. There are three steps to the process of completing the 1031 exchange as described below.
Working with the QI, set up the process to complete the exchange including transferring ownership to the QI before the sale takes place. Then proceed with the sales process of the vehicle(s). This sale can be done to an individual, to a dealer, or through an auction. At transaction closing, all proceeds are directed to an account set up your benefit by the QI. In general, with vehicles, ownership transfers upon payment of the purchase price and acceptance of delivery by the buyer.
Identify replacement property
Identify the replacement property to be purchased within 45 days following the sale of the relinquished property.
Purchase replacement property
Acquire the replacement property within 180 days of the sale of the relinquished property or the due date of the tax return, including extensions, for the year in which the sale occurred, unless the exchange period is otherwise extended by a federal disaster declaration. Proceeds will be paid directly out of your exchange account. Again, it is extremely important that advance planning be done with your qualified intermediary and the auction house prior to bidding on a car at auction.
Remember to keep the following in mind when you are in the process of purchasing a new collector car and you will save both time and money down the road.
- Use a Qualified Intermediary to process a 1031 exchange and coordinate the buys and sells
- When using a QI to complete the process (Both the sale and the purchase). You will not personally see any cash in the transaction.
- Earnest money deposits can be received prior to the closing, but must be wired to the taxpayer’s escrow account at time of closing; otherwise, it will trigger a tax
- Ownership conveys upon payment and when buyer takes delivery
- Exchanges with a related party such as a mother, father, son or daughter requires that the buyer does not sell their new car within two years; otherwise, the tax deferred is due immediately. And you can only purchase from a related party only if the related party is also initiating a 1031 exchange as well.
- The state of the purchased asset is important. If you buy a car in a high sales tax state and drive the car away, then you will pay taxes in that state. But, if you ship to your home state (perhaps lower sales taxes or none at all) then you will be taxed at that states rate.
- If the car that you are purchasing is more than the proceeds from the sale of your old vehicle you are allowed to add funds to the transaction.
- Remember to keep accurate records of all money spent on the car as there is a possibility this could add to the basis of the car.
Vehicle’s that are considered Collectables…
What if you can’t qualify your sale as an investment or a business use asset? Often times we see vehicles appreciate in value but they may have been driven regularly by the seller so they do not necessarily qualify as an investment. This occurs most often when a car is given as a gift to someone most often to children or grandchildren as the recipient or if someone buys a car, drives it for a while, then decides to quit driving the car and store it. Then, years later it is sold for more than purchase price and a tax hit comes into play.
When a gift is given, the recipient of the gift retains the basis and holding period of the person giving the gift. So, if someone was given a 68 Corvette by their grandparents, that they bought new, for a college graduation in 2008 present but then never drove the car, there is a very good chance the car has appreciated over the purchase price that the original owner paid. So, in 2015 when the grandchild wants to sell it they will have a tax hit.
These examples are somewhat rare, but they do happen. Be prepared!!
Is Becoming a Dealer a Viable Option?
An alternative option that some collectors try to take advantage of is obtaining a dealer’s license to avoid state sales tax as well as being able to offset costs associated with the car. Having said that, if you’re a collector and not a legitimate dealer, you would then be making a false claim to the state you’re in which could cause real problems. You could also end up having difficulty properly insuring your classic cars and end up eliminating the capital gains tax break.
Remember though, property held “primarily for sale” is also excluded from a 1031 exchange qualifying requirement. This excluded property would include business inventory for sale. For autos, it means property purchased with the intent to sell it for a gain, such as a quick repair or quick restoration project to be then sold.
At Olympia Ridge we work with car enthusiasts and collectors to help them better integrate their love for autos and motorsports with their financial planning. Whether you like to collect cars, race cars for enjoyment or professionally, like to show your cars at car shows, or just have a love for cars we should talk.