The tax code is very much like a desert in that it can offer mirages to the unwary.

One of the ways this occurs is by transforming what otherwise should be a favorable transaction into one that is much less favorable.

We’ll take a look at one such provision, Section 1239, that converts any gain recognized by a seller on the sale of property to ordinary income if that property is able to be depreciated by the buyer if they are considered related parties.

Section 1239 defines related people as follows:

1. A person and all entities controlled by that person. A controlled entity, for this purpose, means a corporation in which a person owns, directly or indirectly, more than 50% of the value of the outstanding stock; a partnership in which a person owns, directly or indirectly, more than 50% of the capital interest or profits interest; and any entity that is a related person under items 3, 10, 11 or 12.

2. A taxpayer and any trust where the taxpayer (or spouse) is a beneficiary unless the beneficiary’s interest is a remote contingent interest.

3. An executor and beneficiary of an estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

4. An employer, and any person related to the employer, and a welfare benefit fund controlled by the employer or a person related to the employer.

A farm example

Let’s take a look at an example that you might be able to relate to.

Sally and Suzie, mother and daughter, milk cows together in a small partnership. Sally has also been operating a dairy farm as a sole proprietor. As Sally nears retirement, she decides to sell her cows to Suzie. The sale is for $30,000.

Because Suzie is eligible to depreciate those raised cows, Sally will have to recognize ordinary income under the sale.

Typically, the sale of raised cows receives capital gains treatment and is taxed at much lower rates. However, in this case, Sally and Suzie are considered related parties regardless of each of their ownership percentages in the partnership, as the ownership of each of them is attributable to the other.

If Sally were a single taxpayer with $120,000 of adjusted gross income and $30,000 of raised cow sales, she would pay $4,500 in tax on the cows — 15% capital gains rate. However, if that same amount were treated as ordinary income, in the 24% tax bracket, her federal tax increases to $7,200, without factoring in Section 199A’s deduction.

This tax increase is one of the many pitfalls present in the tax desert. Before making that journey, Sally should have been informed of the consequences by talking to a diligent tax professional.

Agricultural businesses are subject to a variety of tax laws such as this one, and nonspecialized advisers and tax preparers may not be familiar with agricultural deductions, allowances, penalties and special requirements.

For more information, visit FarmCreditEast.com/taxplanning.

Arezzo is a senior tax consultant for Farm Credit East, and this article originally ran in the organization’s Today’s Harvest blog.