The Proposed Tax Reform, Losing the 1031 Exchange, and the Collector Car Market

Car collecting

First, this is not a political piece. Seriously. So don’t take any of what follows as political.

Second, I am not a tax professional, an accountant, or even good with math. So don’t take any of what follows as tax advice. Or even general advice.

Keeping those two disclaimers in mind, let’s talk about the proposed new tax bill released last week by the U.S. House of Representatives and what it could mean for car collectors. As both a car collector and collector car dealer, I count myself in this group, and a few things jumped out at me when I read the proposed bill.

The biggest item is revision of the current 1031 like-kind exchange that is often used to defer capital gains tax. The proposal revises the terminology on 1031 exchanges to only apply to real property, as opposed to property. So 1031 exchanges will still apply for real estate but not, for example, art or collector cars. The Senate’s version of the new tax plan also limits 1031 exchanges to real property.

For those unfamiliar with a 1031 exchange, here is a very basic example of how it can work. Let’s say you bought a 1966 Shelby 427 S/C Cobra in 1985 for $100,000. A buyer has just approached you and offered to pay you $2,500,000 for it. You have no documented expenses that would be allowed by the IRS to reduce your $2.4 million gain. Since you’ve owned the car for 32 years, it qualifies for long-term capital gain treatment, which has a top rate of 23.8 percent at the federal level. That means $571,200 in federal taxes are due upon sale, plus whatever your state tax is on long-term capital gain.

However, since we’re pretending, let’s say you’ve always wanted a Ferrari 275 GTB/4. You found one that the owner is willing to sell for exactly $2,500,000. Using a 1031 swap, you can hire an exchange facilitation company and give them the details. You have 45 days to identify the exchange property (the Ferrari, in this case) but I suggest making a list that includes other possible cars as well.  And, please note, the swap doesn’t have to be for just one car, it can be a number of cars that adds up to the exchange amount or even exceeds it if you throw in the extra cash. The facilitator will set up the proper exchange structure, use the Cobra sale proceeds to fund it, handle the necessary paperwork, and then facilitate and execute the ultimate purchase of the 275 GTB/4. I’m simplifying, of course, but basically you can never touch the money from the sale of your car because that would break the exchange. And, if the Ferrari fails its pre-purchase inspection, or the seller backs out, or anything prevents the purchase from happening, you have 180 days total to buy a car from your exchange property list while the facilitator keeps those Cobra bucks in their escrow account.

Car collection
Cars in a Garage

In the end, the 1031 exchange has helped you defer that $571,200 in capital gain tax—less what you pay the facilitator, of course. If you later go to sell the Ferrari, you could do another 1031 exchange and just keep deferring the gains until, if, or when you ultimately realize the profits in the form of a check. At that point, you’d pay the long-term capital gain tax on the total gain(s) above the original $100,000 you paid for the Cobra. So the 1031 has been a handy loophole for collectors who don’t want to cash out of their possessions but instead move cars in and out of their collection.

So what is the implication if the 1031 exchange for cars goes away? And how will it affect the market? Obviously it means more people will pay capital gain tax. And others will get creative, as many already have been, by trading cars via dealer sales or even through auction companies where no money trades hands, only titles do. In many cases these trades can be perfectly legal as long as you track your cost basis and eventually pay the capital gains tax when you turn these trades into a cash payout.

I don’t see losing the ability to have 1031 exchanges having any kind of drastic effect on the car market at large. But there are some other piece of the proposed tax plan that I think will affect the market:

  • There is no proposal to change the aforementioned long-term capital gain rate. Again, I’m in no way a tax professional, or even close, but you don’t have to be a pro to see that paying the top (federal) capital gain rate of 23.8 percent on profit from a car is far better than paying the current top ordinary income rate of 39.6 percent. This preferential treatment on long-term capital gain probably means more to car collectors than anything else. In researching this new proposed tax reform, I ran across a tidbit that claimed a majority of taxpayers with more than $1 million in annual income get roughly half of that from long-term capital gain on investments. The 15.8-percent difference on those kinds of numbers can buy a lot of great cars. Or even restore a 275 GTB/4.
  • There are a variety of tax rate cuts proposed that likely mean more money in the pockets of wealthy collectors. The proposal includes a 15-percent cut in the corporate tax rate from 35 to 20 percent for C Corps. The math isn’t difficult here; that’s a big win for a lot of big companies. And for Pass-Through Businesses (S Corps, partnerships, or sole proprietorships, for example), there’s a proposed pass-through rate cap of 25% at its top level. Another victory.
  • And here’s the biggie: There is a proposed doubling of the exemption and eventual elimination (by 2024) of the estate tax, a.k.a the “Death Tax.” Currently it applies only to inherited assets of $5.49 million or greater for an individual, or $11 million for those filing jointly. How could that affect collectors? Knowing that your heirs won’t have to sell your cars, maybe even your corporation, to pay the estate tax on your collection will certainly remove one concern for people in this rarified air. Especially if the collection consists of gains rolled forward using 1031 exchanges. Sure, some cars that might have been sold to finance estate taxes will remain off the market, but that’s a minor consequence overall.

Bottom line: if passed, yes, I think the new tax plan’s elimination of the 1031 exchange could have a mild effect on the market for higher-value collector cars, where gains are significant enough for owners to defer the capital gain tax on them. A possible result may have owners deciding to hold on to a car instead of paying tax on the gain once they lose the ability to do a tax-free exchange.

But losing the advantage of 1031 like-kind exchanges is a small penalty compared to preserving the tax advantage of a lower long-term capital gain rate. The ordinary income tax rate would still be much higher. Add to that some other advantages for those flying at higher altitudes and I don’t think the new tax plan (in its current form) will have a noticeable negative effect on the collector car market, even with the loss of the 1031 exchange.