Accountants and finance professionals view farmland differently than other capital assets. For example, a retail strip center and undeveloped farmland are both real estate. But their purposes and uses can differ.
For example, raw farmland isn’t depreciable. Land is assumed to have an unlimited useful life. On the other hand, the IRS mandates a specific useful life for residential real estate (27.5 years) and commercial real estate (39 years).
But one thing that farmland has in common with other capital assets is that its sale can lead to a capital gain. And that capital gain can trigger capital gains taxes.
Is it possible to avoid capital gains tax when selling farmland? Not really. But it is possible to use strategies that can help defer or reduce the amount of taxes owed on capital gains generated from the sale of farmland.
Not Just Ordinary Land
Farmland involves more than planting a couple of tomato plants or a few ears of corn. The IRS defines farmland as property actively used to “cultivate, operate, or manage” land for profit. This means that the land must be used as a major profit source by planting, managing and selling vegetables, fruit, livestock, fish, and other products. That farmland might also hold silos, barns, and other storage units to help aid with livestock and produce cultivation and sales. These structures might be treated differently from an accounting standpoint than are produce and livestock.
This is why selling farmland with bells and whistles can be tricky. A farmhouse situated on the land might lead to a different tax treatment than livestock sold along with the land. Additionally, income generated from the sale of livestock is generally considered ordinary income. But a silo or barn sale might lead to generation of capital gains.
Understanding Capital Gains Strategies
While a myriad of tax information is generally required for selling an operating farm, it’s possible to defer or reduce capital gains from the land itself, by using the following methods.
Internal Revenue Code 26 § 1031 lets you “swap” real estate held for business use or investment into other real estate to be used for business or investment purposes. When adhered to, the 1031 exchange process can help defer capital gains taxes. While known as the “like-kind” exchange, farmland doesn’t have to be exchanged for farmland. That farmland can be “exchanged” for an apartment building, as long as that apartment building is of equal or greater value than the farmland.
Transferring farmland to heirs or beneficiaries doesn’t get rid of the capital gains tax. But the heirs or beneficiaries can receive that land as a step-up in basis to the current fair-market value. If those owners decide to sell the farmland a few years down the road, the capital gains taxes could be reduced.
Deferred or Installment Sale
A deferred sale means the seller can push an asset’s sales date into the next year. Meanwhile, an installment sale means the sellers receive proceeds from a sale, over time. Both strategies can potentially reduce capital gains, and the amount of taxes owed.
It’s possible to donate farmland to charity and deduct the full market value of that donated property from your income. The charity can either keep the land or sell it. Though charitable donation deductions can be limited to a percentage of adjusted gross income, excess contributions can be carried forward for up to five years.
Potentially Reducing What’s Owed
As indicated above, selling a farm requires a great deal of forethought and assistance from a tax professional who has expertise in this particular product type. Additionally, any farmland sale will trigger capital gains taxes (assuming the sale generates a profit). But it’s possible to reduce or defer those taxes, which can help reduce a tax bill.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.