Do You Know the Underlying Tax Impact of Your Collectibles?
What Is a Collectible?
One person’s trash is another person’s treasure. That’s never truer than when dealing with collectibles. Collectibles include art, stamps, coins, precious metals, jewelry, comic books, automobiles and other commonly collected items. If you are one of the millions of viewers watching the TV show “Pawn Stars”, you know that a random collectible such as the first issue of the Superman comic books or one of the five 1913 Liberty Head V nickels is worth a lot of money. The less obvious items are often collectibles. For example, a collection of political campaign buttons and badges can be a collectible. If an item is an antique, it is probably a collectible.
Value the Collectible Asset
If you are planning to donate or make a gift of your collectibles that have appreciated in value, it is imperative to have a qualified appraiser value the assets. The federal gift, estate and income tax rules generally use fair market value (“FMV”) from an appraisal report. Therefore, it is crucial to have the appraisal done properly and timely to avoid additional taxes, penalties and interest down the road.
Calculate the Basis
Before you can calculate gain on a sale, you need to determine your tax basis. If you purchased the item, then your basis is the amount you paid, including any buying and selling fees. Many collectibles require special care. You may have spent money to maintain the collectible or restore it. These costs are also part of your basis. Just keep in mind that the definition of what is an acceptable basis deduction is expenses that are “ordinary and necessary” relating to the collecting and trading of your collectibles.
If the collectible is a gift from another person, in this case, your basis is the same as that of the person who gifted the collectible.
If you inherited the collectible, your basis is its FMV at the time of inheritance. Most commonly, FMV is determined by an appraisal, but there are other methods, such as looking at current sales of comparable collectibles.
Tax Consequences of Collectibles
Collectibles are considered tangible personal property, and when sold for a profit, capital gains tax is owed. The IRS views most collectibles as capital assets. Long-term capital gains on collectibles are taxed at 28% rather than the 15% to 20% that applies to most capital assets. Short-term capital gains on collectibles are taxed at your ordinary income tax rate. Moreover, the IRS generally won’t allow you to deduct any losses when you sell collectibles that you’ve held for your personal use.
One way to avoid capital gains on collectibles are swaps. Collectibles like baseball cards and sports memorabilia are considered like-kind property and can be exchanged on a tax-free basis. You are safest making a swap of the same type of collectible, such as baseball cards for baseball cards.
Donate to Charity
Another way to avoid capital gains taxes on collectibles is to donate to charity. Your tax deduction will likely depend both on its value and on the way in which the item will be used by the qualified charitable organization. If the charity’s use of the donated property is related to its tax-exempt purpose, then you are entitled to a charitable income tax deduction equal to the property’s FMV, up to 30% of your adjusted gross income (“AGI”). Otherwise, your deduction may be limited to your cost basis, up to 50% of AGI. For instance, you donated a collection of political memorabilia to a history museum that then puts it on display. This meets the “related use” test. Conversely, if the museum sells the collection, it’s not used for a related purpose, and your deduction may be limited to your cost basis.
If you donate your collection gradually and it continues to appreciate, your deductions will grow with each donation. Donating collectibles gradually can also help you avoid losing deductions that exceed the 30% AGI limit. Although excess deductions can be carried forward for up to five years, you may lose the deductions permanently, if a work or collection is extremely valuable and the carryover period expires.
If you’d like to keep your collection together, but aren’t ready to completely give it up, you can also give a fractional gift by donating an undivided percentage interest in your collection. For example, if you donate a 50% interest in your art collection to an art museum, the museum can display the art for six months each year, and you can deduct 50% of the collection’s fair market value and also enjoy the art for the remaining six months of the year.
Bargain sale is another option to transfer the collectible to charity. In this case, you sell your collectibles to a charity at a price below its FMV. In return, you’re allowed a charitable deduction for the difference between the sales price and the FMV. You must allocate the property’s cost basis between the gift element and the sale element, based on the FMV of each part. The difference between the sale price and the cost basis allocated to the sale portion will be taxable to you as capital gain. There will be no tax on the gain allocated to the gift portion.
There are other rules and regulations when making donations of collectibles. The IRS generally requires a qualified appraisal if a deduction for donated property is worth $5,000 or more. In addition, you’ll need to attach Form 8283, “Noncash Charitable Contributions,” to your tax return. With larger deductions, additional documentation often is required.
Transfers of collectibles to family members or other loved ones, whether during life (gifts) or at death (bequests), may be subject to gift or estate tax. The 2016 annual exclusion for gifts is $14,000 per beneficiary and the life time exemption is $5.45 million per individual, $10.9 million for married couples. If your estate is large enough to trigger a tax liability, you may be required to substantiate the value of the collectible.
For estate tax purposes, if an item, or a collection of similar items, is worth more than $3,000, a written appraisal by a qualified appraiser must accompany the estate tax return. Gifts or bequests of art valued at $50,000 or more will, upon audit, be referred to the IRS Art Advisory Panel.
Even if your estate isn’t large enough for gift and estate taxes to be a concern, it’s important to include all of your collectibles in your estate plan, because an item with little monetary value may have strong sentimental value. Failing to provide for the disposition of collectibles can lead to hurt feelings, arguments among family members or even litigation.
While you pursue your passionate assets, you should also inform your tax advisors of your hobby and trading. They will better position you with the various options that are available for the ownership and effective disposition of your collectible assets. This may mean millions of dollars of tax savings.
For example, let’s say you and your spouse sold a piece of art work for $5 million, you purchased the art for $1 million and invested another $500,000 in restoration and insurance. That means your tax basis is $1.5 million and capital gain is $3.5 million. Following the sale, you now owe a nice check to the federal government in the amount of $980,000 plus state income taxes, depending on which state you reside in. You net around $2.52 million and life goes on.
However, let’s look at an alternative approach that might make this transaction a more rewarding experience for you. With some careful planning, prior to the sale, you transferred the art work to a Flip Charitable Remainder Unitrust (“Flip-CRUT”). A Flip-CRUT is a special type of charitable trust that allows non-income producing assets to be placed in trust and then following a “triggering event”, as defined in the trust document (in this case, after the art work is sold), the trust “flips” to a Standard Charitable Remainder Unitrust (“SCRUT”) and begins distributing income normally to the grantors who established it.
What are the benefits of this transaction to the seller? First, because the balance of the trust will pass to charity at the decease of the tax payer and spouse, there is a charitable income tax deduction available, which will in turn save income taxes. Next, there is no capital gain tax due on the sale, an immediate saving of $980,000 for investment and growth in your portfolio. Further more, Flip-CRUTs are exempt from income tax, which means the gross proceeds of $5 million from the sale are available for reinvestment. Only the income distributed from the trust is subject to income tax. Let’s assume the portfolio earns a 7% return and makes a 5% distribution annually. This strategy will produce an income stream for you that will continue for your lifetime and still have millions leftover to charity. In addition, this will also remove the value of the art work or its sales proceeds from your estate and inheritance taxes. Furthermore, if you choose to leave the charitable gift to your children, you can purchase life insurance outside of the estate naming your children as beneficiaries.
“As you can see, the tax implications are difficult and complicated to sort out. Be sure to explore these and other options for transferring your valuable assets to determine which course is best for you. A tax advisor can help you determine how to properly handle these transactions” suggested Karen Wong, senior tax manager at Buchbinder.
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