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What factors are fueling farmland buying?What factors are fueling farmland buying?

• Strong demand for land, low interest rates and low income tax rates can be beneficial for buyers and sellers of agricultural land.

August 12, 2011

7 Min Read

A number of factors have come together to provide unique circumstances that can be beneficial for both buyers and sellers of agricultural land.

Strong demand for land, interest rates at almost all time lows and long-term federal capital gains tax rates not seen since 1933 are all involved.

Let’s take a look at these factors.

Demand: Interest in farmland is rising globally. Population growth, rising incomes and migration from rural areas to urban locations is driving demand for food products, oilseed and livestock.

The world’s population is growing 1.2 percent annually, firing the increased demand for protein at a 2.5 percent annual rate.

Arable land is declining in China, India and the U.S. The world historically held large reserves of food and fiber in storage, but those reserves have been liquidated due to large scale floods, droughts, or other weather events that have occurred.

China used to carry a year’s corn crop in reserve, but it is down to 20 percent of last year’s crop. At one time India carried almost a year’s reserve of wheat, but it is down to 35 percent. China and the U.S. historically carried 50 percent of a year’s cotton crop, but that is almost all gone.

Institutional investors (pension funds, private equity groups) see farmland as a diversification to their portfolio, an inflation hedge, a safe haven and a source of stable returns.

Seeking long-term returns

Institutional investors seek long-term stable returns of 6-8 percent and that can be done with agricultural land. Since 1970 farmland averaged returns of 12 percent annually, better than the S&P 500, but with the risk of corporate bonds. The only investment that has shown less volatility than farmland long-term returns has been U.S. Treasuries.

Investors have historically done their best to avoid overpaying for agricultural land. They are looking for a 5-6 percent gross cash return, so if land is priced at $3,000 per acre, a cash rent of at least $150 per acre is necessary.

Recent weather events, increasing demand for food, fiber and protein brought on by higher incomes in developing countries and population growth, have contributed to a significant increase in commodity prices.

This in turn, has increased net income levels for farmers, providing the additional cash flows that have contributed to increase the demand for farmland.

Interest rates: According to Federal Reserve Board statistics that began in 1930, the prime rate (what commercial banks charge their best customers) did not exceed 2 percent until after 1950. Since then, it has fluctuated from 3 percent to 20 percent.

The prime rate has been declining since 1980 and during the first week of May 2011, it was 3.25 percent. This current historically low prime rate has translated into low mortgage rates that began around 2004.

Are we taking these low rates for granted? It is easy to forget historical trends. Between 1976 and 1981, mortgage interest rates ranged from 11 percent to in the 21 percent range. That was a doubling of rates in 5 years.

My wife and I bought our first home as a couple in 1986 and we were tickled to death to obtain a 13 percent mortgage rate! It had gone down from 15 percent!

No one knows how long these low rates will last, but some experts sense we are close to a bottom. Many feel there is a greater chance of rates going up than going down, particularly after 2012, when the economy is predicted to have recovered more from the current recession.

Taxes from income: We are in a period of historically low long-term federal capital gains tax rates. Rates have historically been at least 20 percent. The period from 1922 to 1933 is the only period that rates were 12.5 percent or lower.

From 1934 to 1996 the maximum capital gains tax rate exceeded 25 percent and was in excess of 32 percent from 1970 to 1978. This increased to as high as 39.9 percent in 1976-78.

For a married couple filing jointly with $69,000 or less of taxable income, the capital gains tax rate will be 0 percent in 2011.

Capital gain is the profit you make from holding a capital investment such as land. It is also the price received from the sale of farm-raised cull cows.

One example

For example, if you buy a parcel of land for $4,000 per acre and hold it longer than one year and sell it for $5,000 per acre, there is a long-term capital gain of $1,000 per acre.

There can be deductions to this gain to reduce it slightly, but for the purposes of this article the gain is $1,000 per acre. The tax rate applied to the gain is based on the income tax rate bracket of the payor, or in this case the seller of the farmland.

If you sell 50 head of farm-raised cull cows for $1,300 per head, the income of $65,000 receives tax treatment just like long-term capital gain.

The federal government levies a tax on long-term capital gains based on the taxpayer’s taxable income bracket.

Under current law (until the end of 2012), if your adjusted gross income is less than $69,000 for a married couple ($34,500 single), the tax rate for long-term capital gains is 0 percent (10 percent and 15 percent tax bracket).

If your income is higher than $69,000, the rate is 15 percent (25 percent tax bracket and above). Capital gains tax rates have not been this low since 1933. These rates will continue until the end of 2012. Without changes to the tax law by Congress, the top rate will increase to 20 percent beginning in 2013.

As an illustration, let’s say that you bought 60 acres of land for $1,000 per acre and are considering selling it for $2,000 per acre and you have owned the land for 5 years and your taxable income after deductions and exemptions for income taxes is less than $69,000.

The land sale creates a long-term capital gain of $1,000 per acre. So, there is a total capital gain of $60,000 (60 acres x $1,000/acre).

If you sell the land in early 2012 and receive 100 percent of the proceeds before the end of 2012 and your taxable income for income taxes is less than $69,000, you will pay no federal income tax on the capital gain.

If you have $68,000 of taxable income and $60,000 of capital gain you are only paying income tax on the $8,000.

How can this happen?

That $60,000 of capital gain is tax free because you are in a lower tax bracket (up to the top of the 15 percent bracket). This is only effective under current law, which expires at the end of 2012. (Remember that you use up your standard and itemized deductions before you have taxable income.)

These tax rates can be very beneficial to someone considering exiting the dairy business.

Let’s use the example of the cull cow sale from up above. The 50 head sold for a total of $65,000. If that dairy couple has taxable income in 2011 of less than $69,000 (income after exemptions and deductions), they will pay no income tax on the $65,000 of raised cow sales.

If they sell raised cows with a total value of $100,000, they will pay $0 tax on the first $69,000 and a tax rate of 15% on the remaining $31,000, or $4,650 in income tax. In this example, they can sell $100,000 of raised cows and pay $4,650 of income tax on that sale. That is an average tax rate of 4.65 percent.

Unless Congress changes the tax law, the long-term capital gains rate (used for raised, cull cows that are sold, for example) increases to 10 percent from 0 percent and to 20 percent from 15 percent after 2012.

Based on a review of historical documentation, a number of factors have come together to provide unique circumstances that can be beneficial for both buyers and sellers of agricultural land.

Strong demand for land, interest rates at almost all time lows and long-term federal capital gains tax rates not seen since 1933 are all involved.

These examples are for educational purposes only. Consult a qualified tax or investment professional before embarking on capital purchases or the sale of capital assets.

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