We had a reader ask the following question:

“I’m thinking about selling a tract of timber on land that was gifted to me 7 years ago. What can I expect the tax consequences to be? I’m a self-employed farmer.”

We have done a couple of posts lately on capital gains treatment of the sale of equipment and other farm business property.

We thought it would be good to review the rules of Section 1231 since they apply to most of these sales.  Section 1231 governs how the sale of business assets is reported and taxed.  It is actually a fairly nice feature in that any Section 1231 gains are usually treated as capital gains and any losses are treated as ordinary and immediately deductible losses.

For example, lets assume a farmer sells a tractor for $25,000.  They paid $20,000 for it ten years ago and have fully depreciated it.  The first $20,000 of cost basis is considered Section 1245 recapture and is always treated as ordinary income.  The excess $5,000 gain is considered Section 1231 and will enjoy capital gains treatment.

Now lets assume the farmer sold the tractor for $15,000 and they had just purchased it for $20,000 and had not taken any depreciation.  In this case, the $5,000 loss is considered a Section 1231 loss and will be ordinary and immediately deductible.  The reason for it being ordinary is that the law assumes the taxpayer had not yet been able to take the full depreciation allowed to get it down to its actual value at the time of sale.

There is one negative to Section 1231 gains and that is the five year look-back recapture.  If, during the last five years, the farmer had net Section 1231 losses reported on their return and they have a Section 1231 gain this year, part or all of this gain would be ordinary. 

For example, assume a farmer had reported a Section 1231 loss in 2008 of $5,000 and had a Section 1231 gain this year of $10,000, then $5,000 would be ordinary and $5,000 would be capital gains.

For our reader, since it appears this tract of timber was gifted as an investment, the gain on the sale should be treated as a capital gain and subject to a maximum federal tax of 15%.

I received two excellent comments on my post from Monday of this week regarding the cost to some farm families of not having an estate tax for this year.  The comments had additional information which is all applicable for this year.  The main intent of my post was to let farm families know that without proper planning, an estate in 2010 can cost your farm operation a large amount of current or future taxes.

Also, the key problem with the 2010 estate law is that effective January 1, 2011, it reverts back to the law in effect in 2001.  This means that all estates larger than $1,000,000 will be subject to federal estate taxes.  A quarter section of good farmland can exceed this amount alone.  Congress needs to take action and soon to correct this, or thousands of farm families will be much worse off on January 1, 2011 than they were on January 1, 2009 or 2010.

I will keep you posted and keep sending me the comments.

The House on December 3, 2009 passed the Permanent Estate Tax Relief for Families, Farmers and Small Businesses Bill of 2009.  The Act would permanently extend the current exemption of estates of up to $3.5 million for a single taxpayer and $7.0 million for married couples.  For estates larger than there amounts, they would be taxed at the current 45% top rate.

As the title suggests, the House is trying to provide relief to Families, Farmers and Small Businesses.  Additionally, the bill repeals the enactment of carryover basis that was to start in 2011.  This means that people inheriting assets will still be able to use the date of death values (like you can now), instead of using what the basis was for the person that died.  This would probably led to an accounting nightmare.  This bill simply continues the present 2009 law for rates and exemptions.

The negative is that the Bill does not increase the lifetime exemption amount for gifts.  This is still limited to $1 million during life.  It is unclear if the Senate will review this before year-end, so this Bill may not get passed until early 2010 and there may be some changes, but at least it has passed the house.

You should be reviewing your estate plan right now to make sure it is up to date, but with the current law and the proposed changes.