Landowners who have been in the business of farming for many years make decisions that often do not come home to rest until the farm is sold or transferred to the next generation by gift or bequeath. The total impact of these decisions, which began at the time the farm was purchased and continued through each acquisition of depreciable property, affect the income taxes agricultural producers pay while they are farming as well as when the farm is sold or transferred to a new owner. The total cost of buying or selling a farm can easily be overshadowed by decisions that postpone the payment of income taxes.
It is widely known that land is not depreciable and therefore only generates a capital gain tax obligation when it is sold. Capital gain rates will apply, which are generally lower, if the land has been owned for the minimum period of time — more than one year. However, if the land at the time of purchase has improvements on it such as fences, corrals, barns, grain bins or orchards (pecan trees), a portion of the purchase price can be allocated to these assets and a deduction on Schedule F can be taken each year during the time period allowed. Assets have different time periods for recovering their costs through depreciation. Allocating a portion of the purchase price to the attached improvements and deducting depreciation each year allows a farmer to delay the recognition of income by delaying the payment of taxes until a later year. When the depreciable asset is sold, the amount of gain due to depreciation has to be recaptured as ordinary income. If a depreciation deduction was not actually taken, the IRS still requires the amount of depreciation allowed to be recaptured as ordinary income. Income tax is due on ordinary income at the normal tax rate for the farmer’s adjusted gross income level. The postponement of tax is generally a good farm management decision. One must keep in mind that the goal of not paying income tax should not be achieved at the expense of good farm management decisions.
When a farm is purchased with a house on it that the buyer plans to make their personal residence, the amount allocated to the “personal residence” is very important. The tax revisions passed in 1997 allow taxpayers to exclude up to $250,000 of gain ($500,000 for married couples filing a joint return) realized on the sale or exchange of a principal residence occurring after May 6, 1997. To be eligible, the residence must have been owned and used as the taxpayer’s principal residence for a combined period of at least two years out of the five years prior to the sale or exchange. This exclusion of gain on the personal residence can have a huge impact on the cost of selling a farm.
An option that is available to both buyers and sellers of land is an installment sale – a sale of property where you receive at least one payment after the tax year of the sale. This option is attractive to the seller because only a portion of the gain is reported each year. When a payment is received, the amount reported as gain is the same percent of the payment as the total gain is of the total sale price. For example, if a farm sold for $200,000 and the basis at the time of sale was $160,000 (in this example, it is assumed there are no assets included in the sale price that have been depreciated, because any gain due to depreciation has to be recaptured as ordinary income in the year of sale regardless of it being an installment sale), the gain would be $40,000 or 20 percent of the sale price. If the buyer and seller agreed to an installment sale then the buyer would need to report 20 percent of each installment as gain. This provides a farmer an income flow over a number of years and may allow him to be in a lower tax bracket. The interest rate received on the amount included in the installment sale may be more than would be commercially available, plus it allows the tax on the gain to be paid over a number of years. The seller must be careful to separate principal from interest on each installment. The interest portion must be reported as ordinary income.
An installment sale is attractive to a buyer because it allows the opportunity to secure financing and make payments over a period of time at possibly lower interest rates than what would be commercially available. Young beginning farmers find installment sales especially attractive because they have a limited amount of cash to put down and, thus, face more challenges in obtaining financing. Related persons must be careful in using installment sales since this method cannot be used for depreciable property in most cases between related parties. The installment method can be used between related parties for land, since it is not depreciable.
Another item that can have costly implications is acquiring assets by gift versus by bequeath. A donee (person who receives a gift) usually receives the same basis in an asset as the donor (person making the gift) had in the asset at the time the gift is made. Therefore, when a farmer decides to make a gift ($11,000 tax free) to someone, that person will receive the farmer’s basis in the asset. In the case of land that was purchased at a much lower value than the current market price, when the donee decides to sell the land, a sizeable tax obligation could be incurred because of the difference in the low basis and high sale price yielding a taxable capital gain. To the contrary, if the person inherited the asset, the new owner would receive a “stepped-up” basis, which would reflect current market value. When the asset was sold, it would have a higher basis and may generate little or no taxable gain.
These are only a few of the many issues that buyers and sellers of farm business property face. Much has been written on the alternatives and options available to buyers, sellers and those who may want to exchange assets. There are costs and benefits associated with each strategy. The best way to determine which may be the right choice is to sharpen your number two pencils and get out the Big Chief tablet and work through the necessary calculations. It will pay more than most things we do as farmers working on the farm.
This article was contributed by Dan Childs of the Samuel Roberts Noble Foundation.