The Republican Party’s Christmas present to all of us was a new tax law. It made good on several promises, the most notable being President Trump’s promise to get it done before Christmas.
Ballyhooed as the most significant tax reform measure since 1986 — that it definitely is, although reasonable minds can differ about whether that is a good thing or not — it became law without a single Democrat voting for it.
There are many publications that explain the new law for us, but they all try to cover the full landscape. Let’s take a more focused look at what the new tax law might mean for car collectors.
1031 exchanges disappear
Pardon me in advance for expressing a personal opinion, but I’m not all that happy with the Republicans. They said they were going to lower my taxes, not my revenue!
Our firm had a nice little business going handling 1031 exchanges for car collectors, and all of a sudden, they’re gone! Now, 1031 exchanges are available only for real estate.
Aside from my personal financial problems, this effect is a real game-changer for many car collectors who have used 1031 exchanges to move up the collector car ladder without having to send any part of their gains to the U.S. Treasury.
The abrupt end to this fun ride is going to be very expensive indeed.
Let’s say you started with a car you bought for $50,000 — back when collector cars weren’t a big thing. You sold it for $250,000, but were clever enough to run the sale through a 1031 exchange and used that $250,000 plus another $100,000 to purchase Car 2.
A few years later, you sold Car 2 for $750,000 and used another 1031 exchange to buy Car 3 with the $750,000 and another $200,000. Car 3 is now worth $1,350,000, and you’re thinking about taking another step up by trading it toward a $2 million collector car.
Nice thought, but your bank account is going to get crunched pretty hard. Without the availability of a 1031 exchange, the sale of Car 3 becomes fully taxable. How much could that possibly come out to?
The taxable gain is the $1,350,000 sales price less your basis in Car 3. “Basis” is the tax law’s term for your “investment” in the car. Although you actually paid $950,000 for Car 3 when you bought it, that isn’t your basis for tax purposes. You have to reduce your investment by the amount of untaxed gains from the previous exchanges.
The simple math is to look at how much you’ve invested over the years out of your personal bank account. That is only $350,000: the original $50,000 investment in Car 1, the $100,000 you kicked in when you bought Car 2, and the $200,000 you kicked in when you bought Car 3. Your $350,000 basis in Car 3 means the $1,350,000 sale produces a taxable capital gain of $1 million.
Although ordinary income-tax rates have come down slightly, the top rate on capital gains stays at 20%. Also, the net investment income tax has survived, so add another 3.8% to the federal tax. State income taxes are unaffected, so add another 13.3% if you live in California — our highest-tax state. Finally, note that the new tax law limits your state and local tax deduction to $10,000, so you can’t reduce the state tax effect by deducting it on your federal return any more.
All in, you’re looking at up to a 37.1% combined tax rate:
Federal capital-gains tax 20%
Federal net investment income tax 3.8%
State income tax 13.3%
Total 37.1%
That is $371,000 of taxes due, leaving you only $979,000 to reinvest in Car 4. You’ve got to think this is going to persuade a lot of collectors to hold onto whatever they own. That will reduce the market’s available inventory, thereby putting upward pressure on values.
But a lot of buyers need to sell what they own to buy something else. When they sell their existing cars, they lose more money to income taxes. That leaves them less cash to spend, which will put downward pressure on values.
How those opposing forces balance out is a question for an economist, not a legal columnist. But consider one other little quirk in the collector psychology: Sometimes, the need to sell one car in order to buy another is not driven by financial need, but by available space. So maybe there will be some uptick in sales of car lifts and new garage construction to accommodate growing collections.
Capital-gains rate
Legal Files has explained many times that collector cars are not considered “collectibles” under the tax law, so they are not subject to the higher 28% capital-gains rate for collectibles such as art.
Fortunately, nothing in the new tax law affects that definition, and the 20% top rate still applies.
However, the persistent confusion about the applicable rate remains, and many tax preparers still balk at using the 20% rate. If you are being taxed on a substantial collector car capital gain, it is still a useful safeguard to get a qualified legal opinion on the applicable rate. While a legal opinion won’t guarantee the favorable rate, it should be helpful in an audit and should insulate you and your tax preparer from any potential penalties.
Basis step-up at death
A key estate planning strategy has been the so-called basis step-up at death. The theory goes that, since your assets are being subjected to an estate tax at your death, double tax is avoided by changing their basis to their date-of-death values. By raising the basis to value, your family can sell assets right after your death without incurring any income tax.
There was considerable concern that the proposed total repeal of the estate tax would result in the elimination of the basis step-up at death. As it turned out, the estate tax did not get repealed, so the basis step-up at death is still with us.
The basis step-up at death remains the best way to get out of the capital-gains tax. That will motivate many collectors to hold onto their cars for their lifetimes, letting their families sell them afterward without income tax cost. That should reduce the market’s available inventory, thereby putting upward pressure on values.
Increased exemptions
Although the estate tax did not get repealed, the exemptions were doubled. The exact amounts are unknown because the inflation adjustment is being changed retroactively to 2011 to use the Chained CPI rate, and no one has seen the official math.
Estimates are that the 2018 exemption will be just a shade under $11.2 million. Married couples still get to double that, so families won’t see any federal estate tax until their estates exceed $22.4 million.
If your estate is well over those amounts, then it’s estate planning as usual for you. But doubling the exemption brings more estates under the estate tax threshold, making it more attractive to hold cars until death in order to get the basis step-up.
But remember that nothing ever seems to be permanent in this part of the world.
Not one Democrat voted for this bill, so it became law because of the Republican majority. Under Senate rules, tax permanence requires a 60-vote majority. To pass tax legislation with a 51-vote majority, the tax changes cannot have deficit effect beyond 10 years.
To fit within this straitjacket, the doubled exemptions sunset at the end of 2025 — and revert to their current levels as adjusted for inflation. If you’re over the roughly $11 million estate level, that raises questions about the basis step-up strategy. If your car becomes subject to estate tax, that will be a higher rate (40% federal, plus, say, 10% state) than the 36.8% maximum income tax rate.
Valuation discounts
Many collectors have formed family partnerships and LLCs for their car collections in order to be able to discount their values for gift and estate tax purposes.
This strategy makes great sense if your estate is taxable, as your estate tax rate is higher than the income tax rate your family will pay when they sell the cars. However, this is counter-productive when your estate is not subject to estate tax. Essentially, you give up the basis step-up without any offsetting estate tax savings.
With the doubled exemptions, fewer collectors will want to use these entities.
However, if the doubled exemptions sunset before your death, they make more sense. You either need a sharp crystal ball, or some very creative entity design that allows you to toggle the valuation discounts on and off.
Finally, remember the talk about simplifying taxes so much you could file on a postcard? Don’t even go there! ♦
JOHN DRANEAS is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney. He can be reached through www.draneaslaw.com.