Are you an avid collector of a specific item, such as trading cards, rare coins or antique toys? Not only can collecting be an enjoyable hobby, but it also can be financially lucrative if you buy and sell collectibles in the marketplace.
There’s more to this activity than meets the eye, however. As with most investments, there are both pros and cons to investing in collectibles.
Upsides of Collecting
In addition to appreciating an item’s aesthetics, many connoisseurs enjoy the trading aspect of collecting, such as attending swap meets and hunting for bargains at different venues. They may visit trade shows to view other collections or show off their own collection.
Plus, there’s a social element that shouldn’t be overlooked. Often, collectors join clubs to gather with people who share the same interest. They may exchange knowledge, attend events, and even become lifelong friends and travel companions.
Investing in collectibles can also have a financial payoff. Some collectibles, such as fine wines and classic cars, typically appreciate over time. Just ask the owners of baseball cards in mint condition who realized thousands or even millions in gains from selling their prized possessions.
In addition to providing a return on investment, collectibles may serve as a source of diversification for those who are heavily invested in securities, such as stocks and bonds. You can add this asset class to your holdings to help reduce your overall investment risk.
Investors in collectibles face several potential pitfalls, including:
Liquidity. While securities generally may be acquired and sold with relative ease, that’s not always the case with collectibles. Depending on the marketplace, you might get “stuck” holding assets without a reasonable offer on the horizon.
Price volatility. The value of certain collectibles fluctuates widely. Thus, it’s especially important to buy low and sell high. Keep an eye on the market values of your collectibles to avoid dire financial consequences.
Risk of theft or damage. Unlike securities, collectibles may be broken, damaged or stolen. They often require additional security measures, such as liability insurance and lockable cabinets, which can be costly. For example, you don’t want to leave a classic car parked on your driveway.
In addition, you may incur transactional costs when buying or selling collectibles, as well as other related expenses, such as trade show entry fees and travel expenses. In some cases, you may defray costs by working with an auction house. Finally, selling collectibles may open a hornet’s nest of tax issues that may require the input of a tax professional. The federal tax rules differ depending on whether you’re considered a hobbyist, an investor or a dealer who’s in the business of buying and trading collectibles.
Taxes are a mixed bag for collectors. Generally, you must report all sources of income on your federal income tax return, including revenue from hobby, investment and business activities. Long-term capital gains from investing in collectibles are generally subject to a maximum 28% federal tax rate, as opposed to the standard 15% long-term capital gains tax rate (or the 20% federal rate for high-income individuals). In addition, taxpayers may owe the 3.8% net investment income tax.”
However, dealers in collectibles must pay higher ordinary income tax rates on gains from selling collectibles held as inventory. Furthermore, the extent to which you can deduct the related expenses depends on how the activity is classified under the tax code.
Expenses related to a legitimate, for-profit business activity generally are deductible under the tax law. So, if your collectibles activity qualifies as an unincorporated for-profit business activity that generates a net tax loss for the year (deductible expenses in excess of revenue), you can generally deduct the full amount of the loss on your federal income tax return. That means the loss can be used to offset income from other sources and reduce your federal income tax bill.
On the other hand, the tax results are less favorable if your money-losing collectible activity is classified as a hobby, which essentially means an activity that lacks a profit motive. And the rules have gotten less favorable, thanks to an unfavorable provision of the Tax Cuts and Jobs Act (TCJA).
Old rules. Under the rules that were in effect before the TCJA, you were required to report all revenue for hobby activities on your tax return, and your allowable deductions from the activity were limited to that revenue. In other words, you could never have an overall tax loss from an activity that was treated as a hobby, even if you lost money.
Hobby-related expenses (limited to income) were claimed as a miscellaneous itemized deduction. That meant you weren’t allowed a write-off unless you itemized. And, even if you itemized, the write-off for miscellaneous deduction items was limited to the excess of those items over 2% of your adjusted gross income (AGI). The higher your AGI was, the less you could deduct. High-income taxpayers often found their allowable hobby activity deductions limited to little or nothing. Finally, if you were subject to the individual alternative minimum tax (AMT), miscellaneous itemized deductions for hobby expenses were completely disallowed for AMT purposes.
New rules. For 2018 through 2025, the TCJA suspends write-offs for miscellaneous itemized deduction items that, under prior law, were subject to the 2%-of-AGI deduction threshold. That change eliminates all deductions for hobby-related expenses except expenses that you can deduct in any case, such as qualified residence mortgage interest allocable to part of your home used to conduct a hobby.
So, under the current law, you simply can’t deduct most hobby-related expenses for federal income tax purposes. As under prior law, you still must report 100% of hobby-related income on your tax return.
Qualifying as a Business Activity
If you can show a profit motive for your collectibles activity, you may qualify as a collectibles dealer. If so, the activity is treated as a business for federal tax purposes. That means you can generally write off all expenses as costs of doing business — even if that results in a net tax loss. The hobby-versus-business issue has long been an IRS hot button, and the unfavorable TCJA change just adds fuel to the fire. However, the U.S. Tax Court has ruled in favor of taxpayers in cases where the facts and circumstances supported a profit motive even though collecting is often a fun activity.
To make the determination between business and hobby activities, first consider the following safe harbors that automatically qualify an activity as a for-profit business:
- The activity produces positive taxable income (revenue in excess of deductions) for at least three out of every five years.
- You’re engaged in a horse racing, breeding, training or showing activity, and it produces positive taxable income in at least two out of every seven years.
Beyond these safe harbors, investing in collectibles may qualify as a business activity if you can demonstrate an honest intent to make a profit. Factors that can demonstrate such intent include the following:
- You conduct the activity in a businesslike manner by keeping good records and searching for profit-making strategies.
- You have expertise in the activity or hire expert advisors.
- You spend enough time to justify that the activity is a business, not just a hobby.
- You’ve been successful in other ventures, suggesting that you have business acumen.
- The collectibles are expected to appreciate in value.
The U.S. Tax Court also considers the history and magnitude of income and losses from an activity. In general, occasional large profits hold greater weight than more frequent small profits. Likewise, losses caused by unusual events or bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
Another consideration is your financial status. If you earn a large income or most of your income from a full-time job or another business you own, an unprofitable investment in collectibles is more likely to be considered a hobby.
The degree of personal pleasure you derive from the activity is also a factor. This is the Achilles’ heel for most collectors. Many are emotionally attached to items in their collections and frequently socialize with other collectors. These factors may persuade the IRS to classify your investment in collectibles as a hobby, not a legitimate, for-profit business venture.
Get It Right
Is your collectibles activity a hobby or a for-profit business? The answer to that question can have significant tax implications when you decide to sell an item — or if you incur substantial expenses related to the activity. Contact us to learn more – our experienced tax advisors can explain the tax rules and, if your activity qualifies as a for-profit business, help compile the necessary documentation to prove it.