We had a reader ask the following question as a follow up to our post of gifts:

“Please touch on one more aspect of gifting. Gifting grain and the tax owed by the recipient. Thanks, I enjoy your emails.”

Cash method farmers have had many situations where the gifts of farm commodities to family members could be advantageous:

• Moving income to minor children in a lower tax bracket,
• Helping with college costs for children of the taxpayer,
• Supporting parents of the farmers.

With the expansion of the kiddie tax in 2008 to dependents up to age 23 attending college, this reduced the advantage of making gifts of farm commodities to relatives, but not completely.  The farmer still removes this income from their schedule F and if self-employed, neither the farmer or child will pay self-employment taxes on the gift.

One thing to remember is to gift farm commodities that were raised in the prior year since there will be no reduction in operating costs related to the commodity gifted (if gifted in the year of production, you have to reduce your operating costs by amount attributable to the gift).

If the family member is not a dependent under age 24 (if going to college), the income tax effect to them is very straight forward.  The basis in the commodity carries over, most likely zero (unless gifted in the year of production).  The grain is considered a capital asset in the hands of the donee and if sold in less than a year, it is subject to ordinary income tax rates.  If held more than a year, it is subject to favorable capital gains rates.  In the case of parents that the farmer is supporting, they may only have social security income and could easily earn another $10-20,000 of gifted farm commodity income and pay no tax, or if held for more than a year, they could easily double or triple that amount in certain situations for 2011 and 2012.

For dependent children, it is likely that the kiddie tax will apply and the child will pay income taxes on the sale of the grain based upon the farmer’s tax rate.  Therefore, there is minimal income tax savings, but there can be substantial self employment tax savings.

One last reminder is that you must make sure to document the gift properly and the person receiving the commodity must have actual control and ownership before selling the commodity and you should review this with your tax advisor to make sure it is done properly.

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%.

In my previous post, I discussed a situation that applies to many farmers where there was joint ownership of land and whether a partnership tax return is required to be filed.  In that post, I indicated that in many cases, a partnership tax return is required and if one is not filed, then the penalty starting this year is much higher than it has been in the past.

With this post, we will review how to elect not to file a partnership tax return and the advantages to doing it.  In many cases, the mere co-ownership of farm land that is rented to a farm will not be classified as a partnership, however, it is very easy for the landlords to get tripped up in the process.  If the ownership is set up in an new LLC, then usually the IRS is going to assume the entity is a partnership.

The benefits of electing out of a partnership are as follows:

• The owners may make tax elections that are different from each other;
• The loss limitations at the partnership level will not apply;
• You will not be required to file a partnership income tax return.  This can not only save you the cost of preparing a return, but in certain states such as California, the fee to file a partnership tax return (structured as an LLC) can be in excess of $5,000 annually.

If you have determined that you do not want to be a partnership, then the election must be made with the tax return in the year that you want to elect out of the partnership rules.  The partners must all consent to this election.  Even if you fail to make the proper election, it may nonetheless be deemed to have occurred if your facts and circumstances indicate that you intended to do this from the entity inception.

Another important rule is that this election is only available for passive farm rental operations.  If you are a farm partnership performing farm services, you can not elect out of the partnership rules.

My next post, however, will discuss allowing husband and wives to elect out farm operating partnerships.

My partner Scot and I have a 1031 exchange company that handles many tax-deferred exchanges each year.  About this time of year I like to remind our clients that they may be able to sell their land or real estate for cash, yet defer paying the tax on the sale until 2011.

Here is how it works.

1.  Starting around July 4 or each year, you can sell your land for cash to a buyer.  You enter into a tax defer exchange agreement with a qualified company.  The money from the land sale will be parked at this company.

2.  You have up to 45 days to identify your property.  By this date, make sure to identify at least one or two properties that you would like to buy.

3.  After the 45 day date, you have an additional 135 days to purchase this identified property.  This adds up to a total of 180 days.  If you close the sale after about July 3, this 180 date will be in early 2010.

4.  If you are unable to purchase your replacement property, then the company holding your funds will refund it to you.

Under this scenario, this qualifies for an instalment sale treat.  This means that the case you receive in 2010 will be reported on your 2010 tax return and the tax will be owed either March 1, 2011 or April 15, 2011.

If you had a lot of debt paid off at the time of sale, this may not result in much of a tax reduction since that is considered paid off in 2009.

I will update you over the next several months on other ways to save money with tax deferred exchanges.

The American Recovery and Reinvestment Act of 2009 delivered several tax goodies for farmers and their families.  Here are some of the highlights:

1.  Higher Education Credits – You can now have a maximum credit of $2,500 for higher education costs and this applies for the first four years of school instead of the old two year rule.  The phase-outs have been increased substantially so that most farm families will be able to take the whole credit.

2.  First-time homebuyer’s credit.  If you do not currently own a home and have not owned one for three years, you can now get a $8,000 rebate from the IRS.  This applies to any home before December 1, 2009.  The amount is 10% of the home’s price up to a limit of $8,000.  It does phase out if your income is too high.

3.  Making work pay credit.  This credit is intended to partially offset your social security payroll taxes.  The credit is limited to $400 for individuals and $800 for joint filers.  If you work outside the farm for a wage, this credit will increase your take home pay, but your claim the credit on your tax return.  The amount is phased-out depending on income.  This credit is available for 2009 and 2010 (for right now).

4.  New car sales tax deduction.  If you purchase a new car in 2009, you can deduct the sales tax even if you do not itemize or claim state income taxes.

5.  Bonus depreciation.  The 50% bonus depreciation on new equipment purchases is extended through the end of 2009.  For farmers, certain special use buildings may qualify for this bonus.

6.  Section 179 expensing.  This has also been extended till the end of 2009.  This allows you to expense up to $250,000 of equipment purchases in most situations.

7.  Carryback of small business net operating losses.  If you qualify, you can now carryback your net operating loss five years instead of the normal two years.  An eligible small business is if you average less than $15,000,000 in revenues over the last three years.

These are some of the tax goodies that this law is providing.  As usual, you need to discuss these with your tax advisor since there can be complications that are not apparent with the above summary.

I have been reading several articles lately on the possible estate tax law changes that will be coming.  The Bush changes from about 8 years ago will be changed and soon.

Most agree that the estate exemption will most likely be around $3.5 to $5 million and indexed for inflation.  Also, the gift tax exemption will also go back to being the same as the estate tax exemption.  There are also signs that they will allow any unused exemption for the spouse who died to be carried over to the surving spouse.

For example, under the current law, if one spouse dies first and has nothing in their name, their estate tax exemption expires worthless.  Under the proposed changes, if a spouse dies with assets of $2,000,000 and the estate exemption is $3.5 million, then $1.5 million would carry over to the surviving spouse.

A great change for farmers is an increase in the special use allowance up to about $3,5 million.  This allows many more family farms to pass tax free to their heirs and keep it in farming.  The special use valuation is a method that reduces the value of farm property to what it would be worth as farm use only.  Many farmers are close to cities and their land is worth substantially more as development property than farm property.  This special use allows the estate to value it as farmland only.  There are many restrictions on this, but for those who it applies to, it can save substantial taxes and keep the land in the family as farmland.

As these changes wind their way through Congress, I will keep you updated.

The US Court of Federal Claims issued a decision in 2008 indicating proceeds from selling life insurance stock companies that had de-mutualized were in fact tax free.  There have been serveral large life insurance companies such as Metropolitan, Principal, Prudential, etc. that have de-mutualized over the last several years.

The IRS had argued that when these stocks were sold that 100% of the proceeds were subject to capital gains taxes.  The Court ruled that the sales were not taxable, but simply a return of capital.

For more details, including a copy of the decision, please visit the site set up by Chuck Ulrich, a CPA who has battled with the IRS on this matter for many years.

If the sales occurred in the 2005 or later, you can still file an amended tax return to get your refund.  You need to be warned that the IRS has appealed this decision, but for right now, this is the new law on this situation.

Please make sure to check this with your tax advisor, you may be entitled to a very large refund plus interset.

There was a new law passed last year that allows all taxpayers that use the standard deduction to take an extra deduction of up to $1,000 for real estate taxes paid on a personal residence.  This deduction is in addition to the standard deduction.  This deduction applies to farmers who do not itemize their deductions.

I know that many farmers do not itemize their deductions.  This is normally due to their house being paid off and living in a state with low or no income taxes.  If this applies to you this year, please make sure to talk to your tax advisor about this special extra deduction.  It may not be a large deduction, but it is still worth up to $350 or more for farmers in the highest tax bracket.