It’s a new world. When it comes to carried interest, real estate and collectibles, carefully document your purpose for holding these assets
Long-term capital gains associated with assets held over one year are generally taxed at a maximum federal rate of 20 percent — not the top ordinary rate of 37 percent.
Just be careful if you are planning to sell collectibles, gold futures or foreign currency. The tax rate is generally higher.
The more you can document your purpose for holding your assets (at the time of purchase and disposition), the better your chances of a favorable tax result.
The deductibility of net capital losses in excess of $3,000 is generally deferred to future years.
There’s no shortage of confusion about the current tax landscape—both short-term and long term—but here are some steps you can take to protect yourself from paying a higher tax rate than necessary as we march into a new normal world.
The Tax Cuts and Jobs Act lengthens the long-term holding period with respect to partnership interests received in connection with the performance of services. Profit interests held for three years or less at the time of disposition will generate short-term capital gain, taxed at ordinary income rates, regardless of whether or not a section 83(b) election was made. Prior law required a holding period greater than one-year to secure the beneficial maximum (20%) federal long-term capital gain tax rate.
Real estate case law is too technical for the purposes of this article. Let’s just say the courts look at the following factors when trying to determine a personal real-estate owner’s intent:
Number and frequency of sales.
Extent of improvements.
Sales efforts, including through an agent.
Purpose for acquiring, holding and selling.
Manner in which property is acquired.
Length of holding period.
Investment of taxpayer’s time and effort, compared to time and effort devoted to other activities.
Unfortunately, the cases do not lay out a consistent weighting of these general factors. Always check with your legal and tax advisors before engaging in any type of real-estate transaction.
Works of art, rare vehicles, antiques, gems, stamps, coins, etc., may be purchased for personal enjoyment, but gains or losses from their sale are generally taxed as capital gains and losses. But, here’s the rub: Collectibles are a special class of capital asset to which a capital gain rate of 28 percent (not 20%) applies if the collectible items are sold after being held for more than one year (i.e. long-term).
Note that recently popular investments in gold and silver, whether in the form of coins, bullion or held through an exchange-traded fund, are generally treated as “collectibles” subject to the higher 28 percent rate. However, gold mining stocks are subject to the general capital gains rate applicable to other securities. Gold futures, foreign currency and other commodities are generally subject to a blended rate of capital gains tax (60 percent long-term, 40 percent short-term).
Bitcoin and other cryptocurrencies are treated as “property” rather than currency and will trigger long-term or short-term capital gains when the funds are sold, traded or spent. Cryptocurrencies are NOT classified as collectibles.
The difficulties arise if you get to the point that you are considered a dealer rather than a collector, or if you are a legitimate dealer but start selling items from your personal collection. In most cases, the following factors in determining whether sales of collectibles result in capital gain or ordinary income:
Extent of time and effort devoted to enhancing the collectible items
Extent of advertising, versus unsolicited offers
Holding period and frequency of sales from personal collection
Sales of collectibles as sole or primary source of taxpayer’s income
The Tax Cuts and Jobs Act, will end any further discussion about whether gain on the sale of collectibles can be deferred through the use of a like-kind exchange. The tax bill limits the application of section 1031 to real property disposed of after December 31, 2017.
Recommended steps to preserve capital gain treatment:
Clearly identify assets held for investment in books and records, segregating them from assets held for sale or development.
In the case of collectibles, physically segregate and document the personal collection from inventory held for sale.
Memorialize the reason(s) for a change in intent for holding: e.g., death or divorce of principals, legal entanglements, economic changes or new alternate opportunities presented.
If a property acquired with the intent to rent is sold prematurely, then retain documentation that supports the decision to sell: e.g., unsuccessful marketing and advertising, failed leases, news clippings of an adverse event or sluggish rental market.
If a property is rented out after making substantial improvements, then document all efforts to rent, and list or advertise it for sale only after a reasonable period of rental.
Consider selling appreciated/unimproved property to a separate entity before undertaking development. This would necessitate early gain recognition, but may preserve the capital gain treatment on the appreciation that’s realized during the predevelopment period.
Consider the application of Section 1237, a limited safe harbor, permitting certain non-C Corporation investors to divide unimproved land into parcels or lots before sale, without resulting in a conversion to dealer status.
Characterizing an asset as ordinary or capital can result in a significant tax rate differential. It can also affect your ability to net gains and losses against other taxable activities. So you must spend the time and effort needed to document the intent of the acquisition of an asset, as well as any facts that might change the character of the asset, during the holding period.
Sure, we’re all busy. But, in today’s new regulatory and tax landscape, don’t you think it’s worth taking the time to do so in order to potentially cut your future tax rate in half?
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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