The tax consequences of selling a farm or agribusiness should be at the top of the mind of every landowner. For many life-long farmers, selling their farm or business is one of the most difficult decisions they will ever make. Even though putting the farm up for sale makes logical sense in most situations, farmers often have an emotional connection to their land and business that exceeds that of other industries. This article is not going to convince you to sell your property or farm. But, it will discuss many essential accounting tips, tax issues, and post-sale considerations related to the sale of a farm or agribusiness.
The first question farmers generally ask when selling their land or business is “How much do I owe Uncle Sam?” The answer to that question is “it depends.” Generally, the sale of a farm will generate both Capital and Ordinary gains. Capital gains are taxed at lower, beneficial tax rates. In contrast, Ordinary gains are taxed at the same rates as W-2, ordinary income. In most transactions, the sale of the land will create either a capital gain or capital loss. Conversely, the sale of any inventory and harvested crops will constitute an ordinary gain. Items that are acquired and sold during the ordinary course of business, such as inventory and harvested crops, typically also generate ordinary income in a business sale.
The tax treatment of unharvested crops and permanent physical structures (ex: buildings, barns) on the farm is more complicated, but also more beneficial to the taxpayer. Most unharvested crops and permanent physical structures will qualify for Internal Revenue Code Section 1231 tax treatment. Section 1231 applies to depreciable real property and personal property used in a trade or business if the property is held for more than one year. Taxpayers must net all of their Section 1231 property together at year-end, and if the net amount is a gain, then it is treated as a capital gain. If the net amount is a loss, then the loss is treated as an ordinary loss that can offset ordinary income. Section 1231 gains and losses receive the “best of both worlds” treatment because the gains are capital and the losses are ordinary.
The sale of business equipment and machinery is subject to Section 1245 treatment. Section 1245 requires taxpayers to “recapture” a portion of their depreciation taken on this type of property upon the sale. The amount of ordinary gain on the sale of Section 1245 assets is the amount of accumulated depreciation taken on the property. Any remaining gain in excess of the accumulated depreciation is treated as Section 1231 property and netted against other Section 1231 gains and losses. If a business sells Section 1245 property at a loss, there is no recapture, and the loss is treated as a Section 1231 loss. For example, suppose a taxpayer purchased Section 1245 seven-year depreciable property for $14, and their current basis at the end of year five is $4 ($14 less $2 x 5 years). Let’s assume they sell the property for $18. The gain would be $14 ($18 sale price less their adjusted basis of $4). Of that $14 gain, $10 would be recaptured as ordinary income because they had previously taken $10 of depreciation on the property. The remaining $4 of gain would be treated as a Section 1231 gain, subject to netting. Due to the complexities of a sale of business property, farmers should consult their tax advisor regarding the treatment of each asset.
Should a farmer decide to sell his property, there are a few best practices and initial action items to consider. First, farmers should clean up their books, records, and tax returns. One of the things a potential buyer is going to request is three to five years of accounting records and tax returns. Having these reports readily available and ensuring they are well presented and organized will assist in building goodwill with a potential buyer. Second, farm owners should receive both a land appraisal and a business valuation before entering into negotiations with a buyer. There are many business brokers and consultants in the farming industry that are well versed in valuations.
During the transaction, farmers still have several tax planning options and other decisions to consider. A growing trend in real estate is the sale-leaseback transaction. A sale-leaseback is a two-step transaction where a farmer first sells the property to a buyer and then leases the property back from them for a set number of years. These transactions are popular right now because of the current state of the real estate market. Sale-leaseback transactions give farmers capital through the sale but also allow for them to continue working.
Another consideration for a farmer is whether to offer owner financing to an interested buyer. In an owner financing arrangement, the seller receives a significant down payment and then will receive monthly payments of both principal and interest. The interest rate charged is usually a percent or two higher than market rates. Because the most interest is paid during the first few years of a mortgage, offering owner financing is a great way to increase the overall sales price for a seller. Additionally, owner financing allows the taxable gain to be spread over many years rather than fully reported in the year of sale. Careful consideration should be given to the experience and creditworthiness of a buyer. However, in the right situation, owner financing can be very beneficial to both parties in the transaction.
For the portion of the sale related to real estate and land, a farmer is allowed to do a Section 1031 exchange to defer paying taxes. Section 1031 allows a taxpayer to reinvest all of the proceeds in one or many properties and defer paying taxes on the gain. A farmer can exchange their farmland for an income-producing commercial property should they want a consistent stream of income in their later years. Additionally, heirs of an estate receive a step up in the tax basis of the inherited property at death. So, if you are an older farmer, a 1031 exchange can eliminate taxes on the sale of your farm if you reinvest the proceeds and hold the property until death. Additionally, taxpayers who inherit the property would also not have to pay taxes on the property involved in the 1031 exchange.
In conclusion, selling a farm is very complicated, and careful consideration should be given to the many tax issues and opportunities. However, It is possible to navigate this process and still have a favorable tax result. Farmers interested in selling their land or farm should discuss the implications with their tax advisor or attorney.
This article should not be construed as, and should not be relied upon as legal or tax advice.
Tyler Davis is a CPA who works for SVN Saunders Ralston Dantzler real estate as an asset manager and advisor. SVN Saunders Ralston Dantzler was founded by Dean Saunders in 1996 and is a leading agricultural land brokerage based in Lakeland, FL. Tyler also owns his own CPA Firm, Tyler Davis CPA where he provides tax preparation, writing, consulting, and research services. Tyler can be contacted at firstname.lastname@example.org.