Five Key Points
- Higher Taxes: Long-term gains on collectibles face a 28% tax rate, exceeding rates for stocks.
- Hobby or Business? The IRS uses a nine-factor test to determine your collector status, impacting potential deductions.
- Offset Gains: Use losses from other investments to offset gains from collectible sales and reduce your tax burden.
- Tax Strategies: Explore long-term holding, tax-loss harvesting, and charitable donations for potential tax advantages.
- Seek Guidance: Partner with a financial advisor specializing in collectibles to navigate complex tax laws and optimize your investment strategy.
Collectors Collect
While at one of my daughter's swim meets I had an interesting conversation with a fellow father about sports cards. He had a passion for collecting. I have dabbled off and on in the hobby for many years since being really into it in middle school. I have accumulated a minor collection over the years. Like many collectibles, sports cards offer a fascinating blend of financial potential and personal enjoyment. The collectibles market, from rare coins to wine, has captivated enthusiasts and investors for generations. But anytime there is an opportunity for financial gain (or loss), it's crucial to understand the tax implications that can significantly impact your returns.
What are Collectibles?
Collectibles are tangible assets (or rights to digital assets in the case of NFTs) that people acquire and hold for their value, rarity, or historical significance. Almost anything can be collected, and if the right buyer is found, it is potentially valuable, but some of the more common items are:
- Art: Paintings, sculptures, drawings, and other visual creations.
- Coins: Rare coins, commemorative coins, and numismatic collections.
- Sports Cards: Trading cards featuring athletes from various sports. A notable example is a 1952 Mickey Mantle baseball card or a 1986 Fleer Michael Jordan rookie card.
- Stamps: Rare stamps, philatelic collections, and postal memorabilia.
- Watches: Vintage and luxury timepieces.
- Wine: Fine and rare wines.
- Others: This category is expansive and can include comic books, historical artifacts, vintage toys, jewelry, and much more. Examples include Action Comics No. 1 (the first appearance of Superman), a piece of the Berlin Wall, a vintage Barbie doll from the 1950s, or a Tiffany & Co. diamond necklace.
The Tax Landscape of Collectibles
The taxation of collectibles can be complex, primarily due to the IRS's unique classification of them. Profits from selling collectibles are subject to different tax rates and rules than more traditional investments like stocks or bonds.
Gains on Collectibles
You realize a capital gain when you sell a collectible for a profit. The tax rate on this gain depends on how long you held the item before selling it - similar to stocks in this regard:
- Short-term Gain: If you held the collectible for one year or less, your gain is taxed as ordinary income. Your tax rate will depend on your income level. This works just like short-term gains on stocks.
- Long-term Gain: Now this is where the IRS has decided to disadvantage collectibles. When you sell a collectible you've held for more than one year, any profit (capital gain) is taxed at a maximum rate of 28%. This is considerably higher than the maximum rates for other types of long-term capital gains, which are typically 15% or 20%, depending on your income level.
Why the Higher Rate for Collectibles?
There are a few reasons why the IRS has decided to tax long-term gains on collectibles at a higher rate than stocks:
- Discouraging Speculation: The higher tax rate is partly intended to discourage excessive speculation in the collectibles market. The government believes that collectibles are more prone to speculative bubbles and volatile price swings compared to traditional investments like stocks. It's hard to argue with this logic; look at the collectibles markets during COVID when the markets for everything from watches to classic cars shot through the roof and have since crashed. Stocks also increased during that period but not as rapidly, and they have retained more of their value - outside of the "meme stocks" like Gamestop.
- Luxury Tax: Some argue that the higher rate acts as a type of luxury tax on collectible items. Collectibles are often seen as non-essential assets that cater to niche interests and wealthy individuals. It's hard to argue that anyone "needs" collectible items - wine and classic cars would be great examples.
- Tax Revenue: The higher tax rate generates additional revenue for the government. Collectibles are a growing market with wealthy participants, and taxing them at a higher rate contributes to government coffers. Since these are not markets with broad voter awareness or participation, they are easy to tax.
Example: Selling a Painting at a Gain
Let's illustrate the difference in tax implications when selling a piece of art versus a stock, both held for over a year:
Scenario
- Selling Price: $10,000
- Cost Basis (Original Purchase Price): $5,000. For a piece of artwork, the basis may also include holding costs, such as storing it in a climate-controlled warehouse.
- Holding Period: More than one year (Long-term Capital Gain)
Comparison Table
- Tax Rate: The tax rate for collectibles is a flat 28%, while the tax rate for stocks in this example is assumed to be 20% (this can vary based on your income level and tax bracket for the year).
Key Takeaways
The example shows that the tax liability on the sale of the artwork is significantly higher than the tax on the stock sale, even though the capital gain is the same. This is due to the special tax rules for collectibles.
Offsetting Gains and Losses
The good news is that you can offset your gains from collectibles with losses from other investments. For example, if you sold some stocks at a loss in the same year, you can use that loss to reduce your taxable gain from the painting sale. However, there are limitations on how much loss you can deduct each year, and the rules differ for hobbyists versus investors.
Are you a Hobbyist or Investor?
This is where a lot of people get in trouble. They started collecting because they enjoyed the items, like wearing fancy watches or enjoying expensive wine with friends. It was only after they began enjoying collecting that they started to see the possible tax benefits of calling it a business, especially if it is costing them money to collect. Hello, tax write-offs!
However, the distinction between a hobby and a business is crucial for tax purposes and one that the IRS takes seriously. If your collecting activities are deemed a hobby by the IRS, your losses may be limited, and you may not be able to deduct expenses related to your hobby.
The IRS Nine-Factor Test
The IRS uses these nine factors holistically to gauge whether your collecting activities are a legitimate business aiming for profit or primarily a hobby driven by personal enjoyment. No single factor is decisive, but a strong showing on most factors is important to establish your intent to make a profit.
1. Manner of Conducting the Activity
· Business: You maintain separate business records, have a business bank account, advertise your collectibles, and operate with a clear business plan.
· Hobby: You lack formal records, mix personal and "business" finances, and don't actively market your collectibles.
2. Expertise of the Taxpayer or Their Advisors
· Business: You demonstrate knowledge of the collectible market, research trends, and potentially consult with experts to make informed buying and selling decisions.
· Hobby: You mainly rely on personal preferences and casual knowledge rather than systematic research and expert advice.
3. Time and Effort Expended
· Business: You dedicate significant time and effort to your collecting activities, including researching, buying, selling, marketing, and managing your collection.
· Hobby: You spend time on collecting primarily for personal enjoyment, with minimal effort devoted to business aspects.
4. Expectation that Assets Used Will Appreciate in Value
· Business: You have a reasonable expectation that the value of your collectibles will increase over time, supported by market analysis and expert opinions.
· Hobby: You primarily collect for personal enjoyment and may not actively consider the potential for future appreciation.
5. Success of the Taxpayer in Carrying on Other Similar Activities
· Business: You have a track record of success in other business ventures or similar collecting activities, indicating your ability to generate profit.
· Hobby: You have no prior experience in business or collectible investing, suggesting a lack of profit motive.
6. Taxpayer's History of Income or Losses with Respect to the Activity
· Business: You have generated profits from your collecting activities in some years (and have paid taxes on that income), even if you have experienced occasional losses. This demonstrates a genuine effort to make a profit.
· Hobby: You consistently incur losses, suggesting the activity is primarily for personal enjoyment rather than profit.
7. Amount of Occasional Profits, If Any
· Business: You have realized substantial profits from your collecting activities, indicating a potential for future profitability.
· Hobby: Your profits are minimal or sporadic, suggesting the activity is not primarily driven by a profit motive.
8. Financial Status of the Taxpayer
· Business: You rely solely on your collecting activities for your livelihood, demonstrating that it's a separate business venture.
· Hobby: You don't depend on your collecting activities for income, suggesting it may be a hobby disguised as a business.
9. Elements of Personal Pleasure or Recreation
· Business: While you may enjoy collecting, your primary motivation is profit, and you approach your activities with a business mindset.
· Hobby: You primarily collect for personal enjoyment and derive significant personal pleasure from the activity.
The IRS scrutinizes claims of business activity for collecting, so be honest about your intentions and document your activities meticulously.
If you're unsure about your status as a hobbyist or business, consult with a tax professional. They can help you assess your situation and ensure compliance with IRS rules but most times, if you have to ask, it's probably a hobby.
Risks of Aggressive Classification
Attempting to classify your collectible activities as a business when they might better fit the definition of a hobby can lead to IRS scrutiny and potential disallowance of losses. It's essential to maintain proper documentation and demonstrate a profit motive to substantiate your claim.
The IRS typically has three years from the date you file your tax return to audit and disallow losses if they classify the activity as a hobby but it can go further, potentially much further. If the IRS finds that you underreported your income by more than 25%, they can extend the audit period to six years. This extension can apply to reclassifying activities and disallowing losses.
It can be even worse if the IRS suspects fraud or if you did not file a tax return. There is no statute of limitations, meaning the IRS can go back indefinitely to disallow losses and reclassify the activity.
Strategic Tax Planning for Collectible Investors
The tax planning strategies for collectibles are similar to those for investment vehicles like stocks, but with the higher tax rate applicable to them, planning is even more critical. Here are some key strategies to consider:
Long-Term Holding
As mentioned earlier, holding collectibles for over a year qualifies you for long-term capital gains treatment, albeit at a higher maximum rate of 28%. While this rate is higher than that for other assets like stocks, it's still more favorable than the short-term capital gains tax, which is equivalent to your ordinary income tax rate.
Offsetting Gains and Losses
If you have capital losses from other investments (like stocks or bonds), you can use them to offset capital gains from the sale of collectibles. This strategic matching can effectively reduce your overall tax burden for the year. It's a good practice to review your investment portfolio annually and identify potential opportunities to offset gains and losses.
Tax-Loss Harvesting
This strategy involves intentionally selling collectibles that have declined in value to realize a loss. This loss can then be used to offset gains from other investments (as noted above), even carried forward to future tax years. However, it's important to note that wash sale rules apply, preventing you from repurchasing the same or substantially identical collectible within 30 days of the sale.
Charitable Donations
Donating appreciated collectibles to a qualified charity can be a win-win situation. You can claim a tax deduction for the donation's fair market value and avoid the tax on any capital gains on the collectible value growth, all while supporting a worthy cause. This strategy can be particularly beneficial for high-value collectibles with significant unrealized gains.
Professional Guidance
At the risk of sounding self-serving, it may be a good idea to consult with a qualified financial advisor or tax professional who can help prepare a multi-year tax forecast of your income. They can also help you develop a personalized tax strategy that aligns with your investment goals, collectible income (or losses), and financial situation. Tax forecasting can be done on your own, but have you prepared tax rate sensitivity analysis for this year? Every year? Any Year?!?!
Additional Considerations for Collectible Investors
Beyond the tax implications discussed earlier, there are several other essential aspects to consider when dealing with collectibles:
Insurance and Appraisal
Valuable collectibles can be vulnerable to theft, damage, or loss. Obtaining comprehensive insurance coverage tailored to your specific collection can provide peace of mind and financial protection. It's also crucial to obtain professional appraisals for your most valuable items. Appraisals serve two key purposes:
1. Insurance Claims: An appraisal provides documented proof of value in case of a claim, ensuring you receive fair compensation for any covered loss. As your collection becomes more valueable, this becomes more important. Some, more popular collectables such as sports card, have created an entire insustry around the storage and insurance of the items. Once example of of this is PSA's Vault service where they will store your cards in a climate contoled warehouse in Delaware. I only mention the locaiton because if you buy and sell the cards directly to the warehouse, you can also aviod sales sales** (more tax mitigation!).
2. Tax Purposes: When selling or donating a collectible, an appraisal establishes its fair market value, which is essential for determining capital gains taxes or charitable deduction amounts.
Estate Planning
If you own valuable collectibles, it's wise to include them in your estate plan. This ensures that your heirs understand their value and can make informed decisions about their disposition. Proper estate planning can also help minimize potential estate tax liabilities associated with your collection. You can find plenty of examples online of heirs dumping entire collections of various items for pennies on the dollar becuase they do not want to deal with figuring it all out. Have a game plan for your estate and document it well.
Charitable Donations
Donating collectibles to a qualified charitable organization can be a tax-savvy way to support a cause you care about while potentially reducing your tax burden. When donating, you can generally deduct the fair market value of the collectible, subject to certain limitations and IRS rules. It's advisable to consult with a tax professional to ensure you maximize your charitable deduction while complying with all regulations.
By considering these additional factors alongside the tax implications, you can make well-rounded decisions about your collectible investments, ensuring they remain a source of enjoyment and financial security for both you and your heirs.
Let Purpose Built Financial Services Be Your Guide
Collectibles are more than just objects; they're a fusion of passion, nostalgia, and financial potential. However, understanding the ins and outs of collectible taxation, from the unique capital gains rates to the crucial distinction between hobby and business, is critical to preventing costly surprises from the tax man.
At Purpose Built Financial Services, we're passionate about empowering our clients to chase their passions. We'll help you ensure that your passion for collecting does not impact your ability to reach your goals but is instead incorporated into that plan.
Ready to embark on a journey where passion meets profit? Set up a meeting with Purpose Built today for a consultation and let's unlock the hidden treasure within your collection.
Your financial well-being is too important to leave to chance. Choose wisely.
NOTES:
**This is based on their website advertising and you should consult a tax specialist in your location.
Frequently Asked Questions (FAQs)
Q: What if I inherit a collectible?
A: Inherited collectibles receive a step-up in basis to their fair market value at the time of inheritance, potentially reducing future capital gains tax.
Q: Can I deduct expenses related to my collectible hobby?
A: If the IRS classifies your activity as a hobby, deductions for expenses are limited and may be subject to the 2% adjusted gross income (AGI) floor.
Q: How do I prove the fair market value of my collectible for tax purposes?
A: Professional appraisals, auction records, and comparable sales data can help establish the fair market value.
Q: What happens if I trade one collectible for another?
A: The trade is considered a sale and a purchase, potentially triggering capital gains or losses depending on the values of the collectibles involved.
Q: Can I gift a collectible to someone without triggering tax consequences?
A: Yes, but there are annual gift tax exclusions and lifetime exemptions to be aware of. It's best to consult a tax advisor for guidance.
About the Author
Sean Lovison, CPA, CFP®, is a flat fee-only financial planner based in Moorestown, New Jersey, serving clients virtually nationwide. After spending 14 years as a corporate chief financial officer (CFO), receiving and designing compensation plans, he decided to help others navigate their plans.
All written content on this site is for information purposes only. Opinions expressed herein are solely those of Sean Lovison and Purpose Built (PB), unless otherwise specifically cited. The material presented is believed to be from reliable sources, and no representations are made by our firm regarding other parties' informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation.
The information on this site is provided "AS IS" and without warranties of any kind, either express or implied. To the fullest extent permissible pursuant to applicable laws, PB disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose. PB does not warrant that the information will be free from error. None of the information provided on this website is intended as investment, tax, accounting, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circumstances shall PB be liable for any direct, indirect, special, or consequential damages that result from the use of, or the inability to use, the materials on this site, even if PB or a PB-authorized representative has been advised of the possibility of such damages. In no event shall Purpose Built have any liability to you for damages, losses, and causes of action for accessing this site. Information on this website should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.
.jpg)
