Whether you are selling your farm to the next generation, a neighbor or piecemeal over time, structuring the transaction to minimize income taxes is one of the most important factors to consider. This article will briefly summarize the applicable complex tax rules.
Ordinary income vs. capital gains
It is first important to understand the two different tax rates that are involved when selling farm assets. The first, known as ordinary income, consists of the familiar progressive income tax brackets, which are 10%; 15%; 25%; 28%; 33%; 35%; and 39.6%. The bracket amounts depend on whether the taxpayer is single, head of household, married filing jointly or married filed separately. For example, a married couple filing jointly can have $74,900 of taxable income (which is essentially income less exemptions and the standard or itemized deductions) before they reach the 25% tax bracket.
For capital gains, if you are within the 10% or 15% ordinary income tax bracket, any of that income that is capital gains is taxed at 0%. If you are in the 25% to 35% brackets, the capital gains tax rate is 15% and at the 39.6% tax bracket, the rate is 20%. For example, let's assume a married retired couple has income from only two sources: Social Security income of $20,000, and withdrawals from a traditional IRA of $15,000. After the personal exemptions ($4,000 each) and the standard deduction ($12,600), they have $14,400 of taxable income. That means their first $60,500 of capital gains are taxed at 0% (and the next $389,950 are taxed at 15%, the rest at 20%).
If a dairy farmer sells cows or heifers that are at least two years old, the sale of those animals is taxed at the capital gains rate, but the sale of heifers that are less than two years old is taxed at ordinary income rates. If the buyer is buying the cattle for the purpose of milking them, (as opposed to slaughter), then the buyer can depreciate that purchase price. Often, to minimize taxes, a farmer that is easing his way into retirement sells his cows and keeps his heifers (which helps him use up his feed as well). Then, shortly before each heifer freshens, he sells it so that the sale price is taxed at the capital gains rate.
When a farmer buys machinery, he either writes it off in one year (as a Section 179 expense) or depreciates it over ashort time. As such, when that farmer sells machinery, he has to pay ordinary income tax on the whole amount (if he wrote it off as a 179 expense) or on the amount depreciated (at least up to the sale price). Often, this tax is owed in the year of sale, even if the machinery was sold on an installment basis. To minimize taxes, a farmer will lease his machinery rather than selling it. The lease payments are still subject to the ordinary income tax rates but the tax is due over the full lease term as opposed to all in one year.
Like machinery, farm buildings have often been depreciated and as a result, the sale of farm buildings is usually subject to depreciation recapture, albeit under different depreciation recapture rules and rates than machinery.
As we know, land cannot be depreciated under the IRS Code. That means if a farmer paid $500 an acre for land many years ago, and sells it for $10,000 an acre, he has gain of $9,500 an acre, which is taxed at the capital gains rate. In addition, if the farmer had been leasing out the land before he sold it, then under Obamacare, there can be an additional 3.8% tax on the gain from the sale. A savvy and patient retired farmer may sell his land on a land contract to utilize or "fill up" the 0% tax bracket each year and avoid the Obamacare tax.
Please note that this article is only looking at the applicable federal income taxes and not the state income taxes. Also, it is important to note that step-up in basis rules which apply at death can avoid or lessen these taxes. As always, talk to your accountant or knowledgeable attorney before selling your farm.
Halbach is a partner in Twohig, Rietbrock, Schneider and Halbach, S.C., a Chilton law firm that specializes in ag law. Call Halbach at 920-849-4999.