Selling a farm: capital idea or capital gains tax?

Posted on: March 2nd, 2023 by

Note: This is the second of a two-part blog series on buying or selling a farm

Why do you want to sell your farm? Why do you want to buy a farm?

In January, we wrote that before you put your farm on the market or negotiate a farm purchase, you should ask yourself those questions. Your answers will either confirm moving forward with the transaction or lead you to stand pat.

In that article, we mentioned another consideration: taxes. This month, we’ll go into greater detail.

Any significant taxes owed when a farm exchanges hands are likely to be the seller’s responsibility. The buyer’s main tax concern will be annual property taxes going forward (the seller generally pays them up through closing). So, it’s essential that a seller clearly understand their likely income tax liability.

Back to the basis

The main determinant of tax liability is “basis.” Basis is what you paid for the farm when you acquired it. For instance, if you purchase a farm for $1 million, that is its basis. By law, that $1 million you paid is not taxable. If you later sell the farm for $1 million or less, you realized no capital gain. Instead, a capital loss. Only the amount you sell the farm for above your basis is taxable. So, if that $1 million farm is sold for $3 million, only the $2 million above the basis is subject to taxation.

At a long-term capital gains tax rate of 20%, this sale would generate $400,000 in capital gains taxes.

Basis with barns and more

Basis gets more complicated when you consider fixtures– non-land assets attached to the property. These are things like grain bins, hog barns, fencing, tile, and so on. Those items will have their own basis. To illustrate how fixtures can impact basis, let’s say you add $50,000 of fence around your farm. That $1 million farm in our example now has a basis of $1,050,000. You are allowed to deduct $10,000 a year in taxes on that fence because of depreciation. However, this depreciation reduces your basis, so in five years you’re back to a $1 million basis.

Say after the fencing has depreciated away, you sell the original $1 million farm for $3 million. In the previous example you paid only capital gains taxes on the $2 million in gain. However, now you’ve depreciated $50,000 in fencing. For the sake of the sale, the fencing is considered ordinary income. So in our example, you wouldn’t owe capital gains on $2 million, but rather, on $1.95 million and then ordinary income tax on $50,000.

Step-up the basis

Another aspect of basis is step-up in basis. That comes into play when a farm owner dies and the farm is bequeathed to an heir. Whatever the farm is worth when the farm is passed down becomes the new basis, with no income or capital gains taxes paid. If the new owner sells the farm for the new basis value, they owe no capital gains taxes. That can be incredibly valuable to the heir, especially in our example of a $1 million farm later valued at $3 million. Two million dollars of additional value not considered capital gain!

Trading places…and paying no tax

Then, we come to 1031 exchanges. This is a rule that lets you defer taxes if you acquire another farm. It works like this: If you own a farm and you find another farm you’d like to have, you can avoid taxes if you sell your farm and buy the one you’re looking at for the exact same amount. By doing so, you can transfer the basis from your old farm to the new one you now own. You’re telling the government, “I’m not really changing anything but the dirt. The dollars are the same, so don’t tax me,” and they won’t. A 1031 exchange is something to think about if you want to move from one farm to another, or, if you’re being pushed due to situations like development, but it requires legal advice.

A sticky situation

Tax liability can become a real problem if your farm is mortgaged. If a farmer needs to pay down the mortgage and is selling the farm to do it, the bank gets its money and the farmer is left holding the bag on the tax bill. A farmer in that circumstance may be better off holding the farm and making mortgage payments until they are able to sell it, pay the bank, and retain enough to pay all the taxes. This situation is best avoided with scrutiny on the front end – only taking on debt that can be serviced comfortably, by only borrowing a fraction of the land’s value instead of most or all of it. If you feel the need to go to this limit, or you already have, that’s a financial crisis warning sign! In certain cases, Ag & Business Legal Strategies can help farmers use Chapter 12 bankruptcy to escape this tax trap.

If you’re unsure about your farm’s basis, contact your accountant. Annual property tax information is available through your county assessor’s office. If you’re feeling the pinch and unsure how to navigate a sale or negotiate with a banker, give us a call.

We at Ag & Business Legal Strategies are here to help. We are experts in agricultural law and have served dozens of farmers facing financial issues. Contact us today.

At Ag & Business Legal Strategies, we want our clients to be honest with themselves and have a solid business plan. Our attorneys and financial strategist will help you create and execute that business plan, and, if necessary, assist you with the legal, tax, and practical aspects of debt restructuring or bankruptcy.

Don’t wait for the problems to become insurmountable. Connect with someone you can trust today, not tomorrow.

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