How Alternative Investments Are Taxed: Crypto, Art, Real Estate and More

How Alternative Investments Are Taxed: Crypto, Art, Real Estate and More

Taxes on alternative investments depend on the type of asset you hold, how long you hold it, and your income. Here's what you need to know to avoid surprises.

Sep 13, 2021

How Alternative Investments Are Taxed: Crypto, Art, Real Estate and More
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Getting Started

Taxable

Taxable

Tax Advantaged

Tax Advantaged

Rich people buy expensive art to avoid taxes, right? Not quite. As it turns out, profits made from the sale of art are actually taxed at a much higher rate than most investments.

However, some alternative assets—such as real estate and private equity—can come with a much lower tax bill. If you understand the ins and outs of how alternative investments are taxed, you can minimize your tax burden while potentially earning higher returns.

Here's everything you need to know about taxes on alternative assets and how to make the most of your investments.

Understanding the capital gains tax

Any asset you sell for profit can trigger a capital gains tax. The long-term capital gains tax is applied to assets that are held for at least one year, and the rate depends on how long the asset was held, what type of asset it was, and the taxable income of the investor. For 2021, taxes apply to gains on assets sold according to the schedule below.

  • 0% if your taxable income is less than $80,000
  • 15% if your taxable income is $80,000 or more but less than the thresholds below
  • 20% if your taxable income is $441,450 or more for single filers, $496,600 for joint filers, $469,050 for the head of household, or $248,300 for those married but filing separately

Of course, there are exceptions. Gains on certain assets (including art and collectibles) can be taxed at a higher rate of 28%. Investments that offer regular income such as dividends or rental income are often taxed as income rather than capital gains. Assets held for one year or less (for example, if you buy and sell stocks frequently) are usually considered short term capital gains, which are taxed as income—and this is a higher rate for most people. Someone who makes $80,000 in 2021 would pay a 24% tax on short-term capital gains but a 15% tax on long-term capital gains.

Remember, you're paying taxes on gains, not the total value of the asset sold. This is the difference between what you made on the sale of the asset and what you paid to acquire and maintain the asset. The latter is called "cost basis" and can include expenses like trading fees, attorney fees, appraisal fees, and more.

How alternative assets are taxed

The way your alternative investments are taxed depends on the asset and how long it's held. It could be taxed as ordinary income (dividends, interest payments, short-term capital gains, and rental income are often taxed this way) or as capital gains. Here's how some of the most popular alternative assets are taxed.

How art and collectibles are taxed

When you invest in art and other collectibles, such as coins, sports memorabilia, and comic books, any gains you realize are typically taxed at a fairly high rate. You'll pay a long-term capital gains tax of 28% regardless of your income. When calculating your gains for tax purposes, you will get to deduct any restoration fees, appraisal fees, and other expenses like auction and broker fees, according to Galina Portnoy, Certified Public Accountant (CPA) and Tax Director.

"Taxation of art depends on whether the person is an investor or a collector," Portnoy also clarifies. Investors get to deduct these professional expenses as losses, but collectors and hobbyists do not get to factor in any losses. They're only taxed on gains. The distinction between the two, according to Portnoy, lies in whether the item is used for personal or investing purposes. "An investor will store, rather than display, the acquired collectible, waiting for asset appreciation before selling, whereas a collector will display and enjoy the item, and rarely sell it."

It's also worth noting that gold, silver, and other precious metals are also taxed as collectibles. This means that gold ETFs and silver ETFs are too, which often surprises investors who assume that since these ETFs are traded like stocks and don't involve owning physical objects, they'll be taxed like stocks.

How cryptocurrency is taxed

You might assume that since you can buy groceries with Bitcoin, it's considered currency. Well, not according to the IRS, which treats cryptocurrency as a capital asset when tax season rolls around. This means that when you invest in crypto, your earnings are taxed as capital gains just as if you were to invest in any other capital asset.

Because crypto is sometimes spent like currency, though, this can be trickier than it sounds. "The original cost of crypto would need to be compared to the proceeds received," explains Portnoy. This means that if you buy $100 worth of Bitcoin, its value increases to $150, and then you spend it on $150 worth of groceries at Whole Foods (which now accepts Bitcoin), you'll owe capital gains tax on that $50 gain.

How real estate is taxed

Investing in real estate has the potential to provide gains in two different ways: rental income and capital appreciation (when housing prices go up). Each is taxed differently.

Rental income is taxed as ordinary income according to your tax bracket. The profit you make when you sell a property at a higher value than that at which you purchased it is taxed as capital gain, and typically it will fall under the lower long-term capital gains rate because most people hold onto a property for more than one year. You won't owe income taxes on property value appreciation.

Plus, when determining the cost basis of property for tax purposes, Portnoy points out that expenses used to improve the property as well as broker and attorney fees can be deducted. When filing income taxes that include rental income, you can deduct maintenance costs, property management fees, property taxes, insurance, mortgage interest, and utilities.

Tax benefits and disadvantages of alternative assets

The main drawback of alternative investments is that they're more complicated when it comes to taxes. Because different tax laws apply to different assets and holding periods, if you don't have a good understanding of tax law, you might end up making an investment that looks good on paper but ends up costing you enough in taxes to eat up your returns.

However, there are plenty of tax benefits to investing in alternative assets. The biggest benefit is that you'll likely be taxed at a lower rate if you qualify for the long-term capital gains tax. And because you can deduct your losses, your overall taxable gains can be minimized.

Regardless of your tax rate on a given asset, Portnoy reminds readers that alternative assets are inherently valuable for their diversification benefits. "You can’t time the financial markets, but you can minimize your exposure to one particular class of assets by [investing in] alternatives. Since those assets are different in nature, they do not react to market fluctuations the same way." She points out that art and collectibles are particularly useful as they rarely follow market fluctuations—and beyond that, they can be more satisfying to invest in.

How to make alternative investments more tax-efficient

You'll probably have to pay taxes on your investment gains no matter what, but there are strategies that can help you avoid a bigger tax bill when it comes time to sell your assets.

Hold your assets for longer than one year

In most cases, the long-term capital gains tax is going to be a lower rate than the short-term capital gains tax, so you want to hold onto your assets for longer than a year whenever possible. This isn't usually a challenge with assets like real estate and collectibles, but many investors prefer to trade assets like stocks and cryptocurrency more frequently than once a year. This might be worth it if your trading skills are good enough to beat the market, but just keep in mind that your tax bill may be higher.

Deduct qualifying capital losses

Keep track of any expenses and losses on your investment that qualify for deduction under the capital gains tax. Portnoy stresses the importance of keeping purchase records, particularly with alternative assets. "If someone invests in stocks or funds [with a brokerage firm], usually the broker would have the cost basis information," she explains. "For alternative investments, this burden is on the investor."

Sell when your income is lower

Whether your investment returns are taxed as regular income or capital gains, falling under a lower tax bracket works to your advantage. If you're thinking about selling an asset but anticipate making less money the following year, it might be worth it to hold out for one more year so you can qualify for a lower tax rate.

Invest in alternatives through a self-directed IRA

When you invest with a Roth IRA, you're contributing your after-tax money, but your earnings grow tax-free. This can double-up your profits: not only are you avoiding taxes on earnings, but those additional earnings that aren't going to Uncle Sam can be reinvested to help grow your investments even faster. If you're investing in alternative assets, a self-directed IRA is worth looking into. You can use these IRAs to invest in everything from real estate to startups to cryptocurrency and potentially avoid triggering the capital gains tax.

It's crucial to understand how alternative investments are taxed if you're going to invest in them. However, taxes alone shouldn't keep you from investing. By arming yourself with the right knowledge, you can preserve your returns and make smart investing choices.

What about dividends?

When you own stocks or REITs that pay dividends, you may earn small regular payments each month, quarter, or year. Are these dividend payments taxed as capital gains?

What about dividends?

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