So we’re going to follow-up on the first post about basis. As I mentioned, there are a lot of different types of basis when you talk about agriculture. Today, were going to talk about tax basis because it probably comes up the most with your CPA.
For a short, overly-simplified answer, think of tax basis as “what did it cost me.”
Basis probably comes up the most when you are discussing equipment sales. When you sell equipment that you purchased for your operation, you are obligated to report that sale on your tax return and – in most cases – it will be a taxable event. The trick with equipment basis is that you can reduce the amount of the sale by the amount that you paid for the equipment.
At first glance, that sounds great because you purchased that bean head for $75K seven-years ago and you just sold it for $35k. No gain, right?
Nope – what you forgot was you’ve been taking depreciation on that equipment for the past seven-years too (we’re working in old depreciation rules here; new farm equipment can be depreciated in five-years under new tax laws). Here’s what the calculation looks like:
We call it “adjusted basis” because the basis would have just been the purchase price if there wasn’t any depreciation. Depreciation reduces basis because you took it as a tax deduction for those seven-years. In our example, that would reduce it to an adjusted basis of zero. So now you pay tax on that whole $35,000 that you sold it for.
Watch out for depreciation recapture
Here’s the other kicker -- there is something called depreciation recapture, where you add the amount of depreciation back to the gain up to the sale price and add it as ordinary income (which is taxed at your marginal tax rate). The idea is that since you got to take depreciation as a deduction against your ordinary income, you need to add back that depreciation as ordinary income when you sell it.
This is called an “unpreferable tax treatment” because the capital gains rates would be either 0% or 15% depending on your tax bracket.
When you’re working with your CPA at tax time, make sure you are keeping good records on your asset purchases and sales. I recommend sending any purchase agreements and invoices for items greater than $2,500 to your CPA so they have all the information they need to accurately calculate depreciation and the future gain on sale.
The opinions of the author are not necessarily those of Farm Futures or Farm Progress.
Coming soon in By the Books: Increasing or decreasing partnership interest basis through operations