Legal Files” gets a lot of questions, but the most frequent is: “How can I do a 1031 exchange with my collector car?”
This is not much of a surprise. Many readers who have owned their collector cars for some time have realized significant appreciation they want to cash in on. Then they discover that income taxes will take a very large bite out of the successful sale.
Fortunately, for those who have owned their collector car for at least a year, the profit on the sale is taxed as a long-term capital gain. That allows the collector to take advantage of the favorable 20% capital gain rate. Collector cars are not subject to the 28% rate on collectibles because, well, they just don’t fit into the tax law’s technical definition of a “collectible,” no matter what we might think of them.
But that little “deal” evaporates quickly when you get the rest of the story. The gain is treated as “investment income.” Once your investment income exceeds $200,000 ($250,000 on a joint return), which your collector car sale can often assure all by itself, all of your investment income is subject to an additional 3.8% tax. Add in up to about a 10% state income tax, and then consider that the alternative minimum tax will likely prevent you from deducting the state income tax on your federal return, and, bang, you add up to around 34% tax.
Like-kind exchanges
Section 1031 of the federal tax code provides that your gain is not taxed if you exchange one investment asset for another of a “like kind.” This is the tax-saving provision many readers are familiar with in the context of real estate, but it applies equally to non-real-estate investment assets.
Cars are all considered to be like kind. So, you can exchange your Porsche for a Ferrari without any worries. However, you can’t exchange your car for real estate, or vice versa.
Equalizing the exchange
You can do multiple car exchanges. For example, our office is currently in the midst of an exchange of eight Porsches for one Porsche. We’ve handled another exchange where one valuable car was replaced with 15 less-valuable cars.
Obviously, you can’t always make the value of the cars come out the same, so when that happens, you have no choice other than to equalize the exchange with cash. If you add cash to buy the replacement car (trading up), all is fine. You’re still tax-free, and the cash simply adds to your basis (investment) in the new car. But when you trade down and receive cash as the equalizer, the cash is taxable.
This often surprises people — all of the cash is taxable, to the extent of the overall gain.
Consider a simple example: You have $500,000 invested in a $1,000,000 car. You exchange it for a $500,000 car plus $500,000 in cash. Most people think they would pay tax on half their gain, since they reinvested half the money. Unfortunately, it doesn’t work that way. All of the $500,000 is taxable, as the cash is treated as profit first.
Deferred exchanges
As it’s not easy to find someone who wants your car and will trade you a car you want, the law allows you to use an exchange accommodator to sell your car and replace it in a separate transaction. The rules are very technical, and little mistakes can make the whole thing taxable.
The first step is finding a buyer for your collector car. Once you do, but before the sale is completed, you enter into an exchange agreement with an independent exchange accommodator — or a “qualified intermediary,” in tax-speak.
Pursuant to the exchange agreement, you transfer title to your car to the buyer, but the buyer pays the purchase price to the accommodator, who holds it in escrow for use in buying the replacement car(s).
The first problem for many collectors is actually setting this up before the sale occurs.
Our office has dealt with situations where the seller suddenly thinks of doing an exchange when the seller has received a substantial nonrefundable deposit, when the broker is already holding the full purchase price, when the car is loaded in a container and halfway across the Atlantic — and similar last-minute scrambles. We haven’t been able to bail out all those situations, and waiting that long creates a lot of anxiety. Plan ahead!
45- and 180-day timers
Once you relinquish ownership of your car, the clock starts ticking simultaneously on two timers — a 45-day limit and a 180-day limit.
You have a maximum of 45 days to “identify” one or more potential replacement cars to the accommodator. Describing a model isn’t enough. You must identify specific cars with VINs, license numbers and so on. Once the 45 days runs out, the cars you have identified become the only cars in the world that can be purchased as part of the exchange. If your negotiations fail — or if someone buys the cars out from under you — you’re done and you have to pay the tax.
You can identify multiple cars to have some choices, but you can’t go hog wild. The law limits you to identifying either three cars regardless of their value, or any number of cars so long as their total value does not exceed double the sales price of your car.
The second limit is that the entire exchange must be completed within 180 days. That’s 135 days after the 45 days.
Buying the replacement car
The purchase process is the reverse of the sale. You contract to purchase the replacement car you want. Then you instruct the accommodator to purchase it for you with the exchange funds. The seller then transfers title and possession of the car directly to you.
Expenses
Selling expenses — such as broker’s commissions, accommodator fees and other costs — can be paid by the accommodator and treated as a reduction of the sales price. If you paid any of them yourself, the accommodator can reimburse you.
Selling expenses should include any repairs that you might be required to make to your car as part of the sales contract. However, repairs that you make ahead of time to get the car ready for sale should not be paid by the accommodator.
Although there is no clear guidance on this, the accommodator should be able to pay, as part of the acquisition cost of the replacement car, any transport fees, import duties, etc., incurred in getting the car to you.
Restoration work
It is complicated, but you can make restoration work done on the replacement car part of the exchange. Theoretically, parts and labor are not considered to be of “like kind” with a car. However, once the work is completed, it becomes part of the car and then it is “like kind.”
For that reason, the replacement car must be acquired by the accommodator and the accommodator must contract and pay for the restoration work before the car is transferred to you. This raises two practical problems: It requires more accommodator fees and likely a more car-savvy accommodator.
Since the work must be completed before the 180-day period expires, the amount of restoration work that can be done becomes limited. There may not be much time left by the time the car actually gets to the shop and work starts. Work done after the 180th day does not qualify as part of the exchange, even if paid for before then.
Buy and then sell
You can do a reverse exchange, in which you buy the replacement car before selling your car.
To do this, you start with an interest-free loan to the accommodator to use to buy the car. The accommodator must then arrange for storage pending completion of the exchange.
Next, you find a buyer for your car. The buyer then pays the purchase price to the accommodator. Next, you identify the new car as the replacement car. The accommodator then transfers the new car to you as the exchange for the old car, and uses the sales proceeds from the sale of the old car to repay your loan.
A reverse exchange is a more complicated transaction, and it has you doubling up on your investment temporarily. Plus, the entire transaction must be completed within 180 days after the accommodator acquires the new car.
Auctions
It’s easy enough to sell the old car or buy the new car at auction. However, doing both on the same weekend takes some careful coordination.
First off, you have to get your accommodator and your auction company on the same page before the auction weekend. Everyone needs time to handle the paperwork.
It’s pretty easy if you sell and buy at the same auction, as the auction company offsets dollars internally. But if you sell at one auction and buy at another, you have to get the two auction companies connected.
The practical problem is the cash flow. Auction buyers typically settle their accounts on the Monday after the auction, but it then takes several weeks before the sales proceeds are disbursed to the seller.
You have to convince the selling auction company to hurry its internal administration, so it can disburse immediately and the sales proceeds can go to the buying auction company in time to settle the purchase. That puts a lot of stress on both companies, and they won’t do it every time they are asked. ♦
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.