The federal income taxation of gains (and losses) from the disposition of investments in collectible assets (collectibles) is relatively unfamiliar to many practitioners for several reasons. First, the tax definition of collectibles is complex and can easily be misinterpreted. Second, the netting process for collectible gains and losses is more complicated than it is for typical capital gains and losses. Finally, the applicable tax rate for net collectible gains is different than for other capital gains and losses. This article assists tax practitioners in understanding the definition of collectibles for tax purposes, explains how gains from collectibles are taxed, and provides practical strategies that taxpayers can use to lower their tax burdens on collectible gains.
Since 1997, the distinction between a collectible and other types of capital assets has mattered for purposes of the capital gains and losses netting process and the tax rate on net capital gains (excess of net long-term capital gains over net short-term capital losses). Before the Taxpayer Relief Act (TRA) of 1997 was enacted, (1) the entire amount of net capital gains was taxed at a maximum rate of 28% with no distinction made for the type of long-term capital gain. Afterward, the maximum tax rate on net capital gains was reduced to 20% for gains on most capital assets.
However, in passing capital gains tax reform as part of the TRA, Congress defined collectibles separately and chose to leave the maximum rate assessable on collectible gains at 28%. (2) Those in favor of taxing collectible gains at a higher rate than other capital gains argued that collectibles were mostly owned by the wealthy and that gains from those collectibles neither motivated innovation nor stimulated economic growth. (3) They further maintained that taxing collectible gains at a higher rate produced desired vertical tax equity while still being politically palatable. The challenge for the drafters of the legislation in applying the higher tax rate for collectibles was in defining the term "collectible."
Under the current tax system, there are three categories of capital gains. The first category, and most common, is capital gains subject to a rate of 0%/15%/20%, depending on the taxpayer's taxable income exclusive of these gains. These gains include capital gains other than capital gains in the other two categories. The second category of capital gains is unrecaptured Sec. 1250 gain. These gains are subject to a maximum 25% rate. The final category of capital gains is collectibles. Collectible gains, the focus of this article, are subject to a maximum rate of 28%.
Collectible gain and loss defined
Sec. 1(h)(5)(A) provides that a collectible gain or loss means a gain or loss from the sale or exchange of a collectible that is a capital asset held for more than a year. Thus, for example, gain from the sale of a collectible held as an investment (e.g., antique furniture) for more than a year by one taxpayer could potentially qualify as a collectible gain, but the same asset owned by a dealer for sale as inventory (not a capital asset) in the ordinary course of business would be ordinary income no matter how long the dealer held the asset. (4)
Sec. 1(h)(5)(A) provides that for an asset to be a collectible for income tax purposes, it must meet the definition of a collectible provided in Sec. 408(m). Sec. 408(m) was originally enacted to prohibit speculative asset investment in collectibles within an individual retirement account (IRA). The cross-reference from Sec. 1(h)(5)(A) to Sec. 408(m) increases the complexity of the collectible definition for purposes of determining the netting process and applicable tax rate for collectible gains and losses. Sec. 408(m)(2) defines a collectible as:
* Any work of art;
* Any rug or antique;
* Any metal or gem;
* Any stamp or coin;
* Any alcoholic beverage; or
* Any other tangible personal property specified by Treasury.
Prop. Regs. Sec. 1.408-10(b) (5) expands the Sec. 408(m)(2) definition of a collectible to also include:
* Any musical instrument; and
* Any historical objects (documents, clothes, etc.). (6)
Sec. 408(m)(3) excludes certain metal coins and bullion from the definition of a collectible for purposes of the IRA provisions. However, Sec. 1(h)(5)(A) explicitly denies the Sec. 408(m)(3) exception for gold and silver coins (e.g., American Eagle coins) and bullion for income tax purposes and instead treats these coins and bullion as collectibles for purposes of computing the income tax.
While it is clear that gold and silver coins are collectibles, what about bullion-backed precious metal exchange-traded funds (precious metal ETFs)? Are they also considered collectibles? Because precious metal ETFs (e.g., gold, silver, platinum, and palladium) are physically backed by precious metals such that each precious metal ETF share represents ownership in the underlying precious metal, precious metal ETF shares are considered to be collectibles. (7) Examples of common gold ETFs include SPDR Gold Shares (GLD), iShares Gold Trust (IAU), and ETFS Physical Swiss Gold Shares (SGOL). As the spot gold price has risen from around $350 per ounce in 1997 when the TRA was passed to over $1,500 per ounce in the fall of 2019 (reaching a maximum of nearly $1,900 in 2011), some investors currently may have significant unrealized gains in gold coins, gold ETFs, and other precious metal ETFs that are exposed to the higher capital gains tax rate applicable to collectible gains. Taxpayers may be unaware that these gains are potentially subject to a higher tax rate than gains on other types of investments.
A common misperception is that an asset is not a collectible for tax purposes unless it is explicitly identified in either Sec. 408(m) or Prop. Regs. Sec. 1.408-10(b). However, as provided in Prop. Regs. Sec. 1.408-10(b), the IRS has the authority to deem any tangible property not specifically listed in either Sec. 408(m) or Prop. Regs. Sec. 1.408-10(b) as a collectible for Sec. 408(m)(2) purposes and, thus, by reference for Sec. 1(h)(5) purposes. For example, collectibles could include restored automobiles, (8) valuable baseball cards, or even rare comic books. Thus, taxpayers who did not report gains from the sale of these assets as collectible gains simply because these assets were not explicitly listed as collectibles in either Sec. 408(m)(2) or Prop. Regs. Sec. 1.408-10(b)(8) might be exposing themselves to potential tax underpayment penalty risk under Sec. 6662(d). (9)
Taxpayers and their advisers may be unaware that the definition of collectible gains also includes gains, but not losses, from the sale of an equity interest in a passthrough entity (i.e., a partnership, S corporation, or trust) to the extent the gain from the sale is attributable to unrealized appreciation in collectibles owned by the passthrough entity. (10) Thus, for example, if a taxpayer sells a partnership interest that owns a collectible, the taxpayer is required to include his or her share of the unrealized gain, if any, from the collectible upon the disposition of the partnership interest as if the partnership had sold all of its assets individually and allocated gain from the collectible to the partners. That is, the passthrough entity owner is required to recognize as collectible gain the amount of gain (but not loss) that would be allocated to that owner if the entity were to sell all of its collectibles for cash equal to the fair market value (FMV) of the assets in a fully taxable transaction immediately before the sale of the passthrough entity ownership...