The Wall Street Journal-20080214-If You Collect- the IRS May Collect From You- Capital-Gains Tax And Estate Levies Could Be Payable

Return to: The_Wall_Street_Journal-20080214

If You Collect, the IRS May Collect From You; Capital-Gains Tax And Estate Levies Could Be Payable

Full Text (706  words)

Oil paintings, old cars or Elvis's guns: Whatever you collect is a tax bill waiting to happen.

Capital gains, estate and gift taxes may all come into play depending on whether you decide to sell off parts of the collection or bequeath it to an heir.

Experts advise that you start by deciding your tax status: collector, investor or dealer. Tax rules recognize these three categories, and deductions are handled differently for each under the Internal Revenue Code.

A collector, for tax purposes, is one who buys and owns items primarily for personal pleasure. An investor, on the other hand, buys chiefly to make a profit. A dealer is in the business of buying and selling.

For the average person, the big distinction is between collector and investor. Collectors can't take a deduction for keeping up a collection because expenses are considered personal under Section 262 of the code. Investors, however, may deduct costs as expenses incurred in the production of income under Section 212.

To prove that you are an investor, for example, you must be able to show that you are tracking ups and down in the value of your objects. It's a good idea to get appraisals on a regular basis and subscribe to journals that help keep a pulse on the market.

"It's always good to keep businesslike records, keep an inventory and watch market trends," says Ralph E. Lerner, a partner in the New York office of law firm Sidley Austin. "If you don't, then you look more like a collector."

Once you've established your tax status, give some thought to what you are planning to do with the collectibles in the long run.

If you sell them, you will pay a special 28% capital-gains tax, nearly double the current 15% rate for long-term capital gains on other investments.

Don't hold your breath waiting for the capital-gains rate on collectibles to be lowered. A perennial fight over this issues keeps the legislative pot stirred; a bill now in the Senate would cut the rate from 28% to 15%, but many in the art business don't expect that to happen anytime soon.

"I think it's exceedingly unlikely to move this Congress," says Robert Kerr, senior director of government relations at the National Association of Enrolled Agents, which represents a group of tax preparers federally licensed by the Internal Revenue Service.

Another option is to swap one collectible for another. A strategy called a "like-kind exchange" can let you do this and defer capital- gains tax. Such exchanges, often used with real estate, can also be used on stamps, coins, gems and other collectibles. It's tricky, though, and may only be used by investors.

How do you do a like-kind exchange? "Very carefully," says Claudia Hill, an enrolled agent who owns the tax services company Tax Mam Inc., in Cupertino, Calif. "While the law allows it, the difficulty is in assuring the assets being exchanged are 'like kind.'"

If you don't plan to sell, you need to think about estate and gift taxes because the collectibles will be included in your estate at their fair-market value. (Determining fair-market value requires a number of actions, including having the items appraised.)

Estate-tax planning is complicated, especially right now, because a 2001 law phased in a series of complex changes. This year, a tax of as much as 45% will be levied on estates worth more than $2 million. In 2009, the threshold will rise to $3.5 million. In 2010, the tax will be lifted completely for a year, but reinstated at a lower threshold in 2011.

The estate-tax return is due nine months after death, according to Jere Doyle, senior vice president of Bank of New York Mellon Corp. A shortage of cash may force a sale of the collectibles to pay the estate tax.

Failing to anticipate the estate tax can make heirs' lives "miserable," says Mr. Doyle. "The estate tax is one reason why a charitable gift of collectibles is a good idea. The amount given to charity is deductible for estate-tax purposes."

Lifetime charitable gifts are also an option, but they must be planned carefully to let the collector reap a maximum tax benefit. The rules on such deductions are more complicated.