One of our mistakes in the beef business happens when we start believing that Uncle Sam's depreciation schedules have something to do with real depreciation.
Real depreciation relates to the true value of something as it ages and/or declines. An example is this: a new-purchased tractor may hold far more value, far longer, than the straight-line depreciation schedule allowed by the IRS. When you sell that used tractor for a reasonable price, you'll have to make up the difference between the value to which you depreciated it and the higher price at which you sold it.
This difference between Uncle Sam's depreciation and actual value can offer advantages, even opportunities. One of those is the difference between real cow depreciation and IRS cow depreciation schedules. It's another of those things I mentioned in my April 16 blog, "Sorting out profit definitions depends on where you live," that Wally Olson from Vinita, Okla., has been schooling me on for some time now.
Until I spent the day with Olson a couple weeks ago, I had never quite grasped the entire picture.
The first thing to recall is that cows rarely depreciate in real terms during their first four or five years of life. Occasionally they appreciate in value. After about age 5 and the birth of their third calf they commonly begin to drop in value up until 10 years of age or so. Right now, during herd expansion, demand has been so high for cows that even 6-year-old cows may be worth as much as younger cows or even worth as much as fancy bred heifers.
Olson has pointed out this real depreciation "schedule" to me several times, but until that day I had generally failed to understand how one can act profitably upon it.
The normal IRS depreciation schedule for a purchased cow is either 5 or 7 years, with equal depreciation in each of those years. That means she might be depreciated out with a tax basis of zero at 5 years old, yet have a real value as high as a bred heifer, or certainly as high as a bred 2nd-calf heifer.
Raised heifers have no cost basis and therefore cannot be depreciated, although you are allowed to deduct costs for raising and developing them, such as feed, medicine, vet bills, and breeding costs.
Knowing your bovine inventory >>
Olson says your opportunities lie in these bits of knowledge.
He says you must know your bovine inventory by age, class and value and you must sell into markets that offer premiums to capture potential profits, but he says it can be done, even with cows. Essentially, you could sell younger cows at peak value, thereby accomplishing two important things:
1. You would be capturing top value instead of losing money by keeping cows until their value drops.
2. You would turn money over as in a stocker operation, rather than letting it wither away in aged cows.
All the while you are still producing calves with those young cows, just as any other cow-calf operator would do.
In recent years, Olson has been buying lower-priced young heifer calves, developing them to breeding age, then breeding them to bulls he likes. Those which don't get bred go to market as stocker/feeder heifers. That money comes back to Olson in weight gain and sometimes by marketing them at prices better than he bought them.
Olson has been keeping the heifers which produce calves until an opportunity comes along to sell them at a good profit, nearly always before they reach 4 or 5 years of age. This is the marketing-trading-planning part of his program.
Tax matters too
There can also be tax advantages worth capturing.
The differences in purchased versus raised breeding stock may offer further opportunities because of differences in whether profits from breeding-stock sales are counted by the IRS as "capital gains" or "ordinary income." Capital gains rate will cost you less than ordinary income tax rate.
If purchased cattle are sold for less than the purchase price, all gains are also considered ordinary income.
Any monetary gains on purchased cattle which you later sell for more than the purchase price are considered both ordinary and capital. Here's how: The profit between the gross sale price and your purchase price is considered to be capital gains, while the remaining part of the gain is considered to be ordinary income. This part of the gain likely would be the difference between your depreciated basis and your original purchase price.
Of course, Olson notes that tax planning can save plenty of money but he notes, as my accountant always has, that you should set your sights on making a profit and let tax planning take its place in the course of business.