Disclaimer: All references to tax law refer to US tax law under the Internal Revenue Service (IRS). Posts are my thoughts only and should not be taken as authoritative statements of the law. I once held a CPA certification, but it is no longer active. Please do your own research and consult a licensed professional for all legal, tax, and accounting matters.
It's been said that there are only two certainties in life: death and taxes.
The tax implications from selling your LEGO can vary depending on many factors. According to the IRS, whenever profit is made on a transaction, the result is taxable income. Realistically speaking, since it is usually up to the seller to self-report the taxable income, there are hundreds of thousands of transactions every day that "fall under the tax radar." Selling a few sets on eBay may keep you under the radar for a while, but the more transactions you do and the more money you make will speed up the inevitability that sooner or later, you will have to pay taxes on your profits. (Note: the biggest exception to self-reporting is If you make more than $600 in a year from any one source, you may get a "1099-MISC" from that source which reports your income to the IRS.)
So how is my LEGO income taxed?
Because the US tax code is so vast, there are a number of different ways your LEGO income could be taxed. In my experience, there are three main categories: hobby, investment, and business.
If your LEGO activity is a hobby, it means you have no intent on making a profit and can only deduct expenses up to any income. This classification is not actually desirable from a tax perspective and the IRS uses it to re-class "business losses" that some taxpayers use to offset other income.
Most of us that are using the "buy and hold" technique would classify our LEGO as an investment....and the IRS would agree. According to IRS Topic 409, collectibles are considered a "capital asset" for tax purposes. Think of your LEGO as in the same category as artwork, coins, stamps, or any other collectible that may hold value. So what does this mean to your LEGO profits? It means that the tax you owe depends on how long you owned the product. If you sell LEGO that you held for less than 1 year, then it is considered a short-term capital gain, it is taxed at your normal income tax rate (up to 39.6%), and you can only net your short-term capital losses. If you had owned that same LEGO for more than 1 year, then the profit is a long-term capital gain, taxed at a maximum of 28%, and can be netted against any long-term or short term capital losses. Furthermore, you can deduct up to $1500 in net capital losses per year ($3,000 if filing jointly with spouse) against your normal income and can be carried forward to future years. So long-term classification is better from a tax perspective, but you cannot deduct property held for personal use - it has to be an investment. Capital gains and losses are reported on Schedule D and reported on an individual tax return (1040).
Lastly, those that engage in LEGO buying and selling with an intent to make profit may classify their activity as a business. This classification has pros and cons. Pros include the ability to "write off" all expenses related to your activities and even report a tax loss on your tax return (offsetting your other income). The cons are mostly twofold: 1) many, many more documentation requirements and 2) paying self-employment taxes (currently 15.3%) on net income. Business income is reported on Schedule C of the 1040 return unless you've registered as a partnership, LLC, or Corporation.
There is no cut and dried rule regarding whether your activity would be viewed by the IRS as a business or not, but generally speaking, they look at how much time you put in, the manner in which you carry out the activity, and your past history of profits and losses. In other words, if it looks like a duck, quacks like a duck, and walks like a duck....it's probably a duck. If you run a website or store, have business cards, and turn a monthly profit...chances are your LEGO activity is a business. If you buy and hold some sets to sell in future years...chances are it's an investment. Real Estate investors/flippers must also wrestle with these issues.
Do I really have to report my LEGO income?
One of the most common questions with selling stuff second-hand is "do I have to pay taxes?" Well, the answer is "yes" according to the law. But in reality, many people don't report their second-hand or online sales. My gut tells me that there are plenty of people making a large amount of money that goes unreported. However, if the IRS ever comes a-knocking in the form of an audit, those people will end up owing a lot of money. Similar to the "LEGO [email protected] Blacklist" conversation, seemingly the best way to stay under their radar is to limit your transactions. Regardless, every LEGO investor should have a plan in mind when starting off as to what type of investor they will be and how to handle their tax responsibilities.
I hope this post has been insightful. I hope to post more blogs about the business side of LEGO - including how to start a LEGO business and different accounting and budgeting tips. I look forward to hearing from anyone who already runs their LEGO activity as a business. /Matt