If you are considering selling a farm or ranch, there are important tax and financial planning issues of which you need to be aware. a sale can involve significant income tax consequences and important estate planning considerations. advanced planning prior to a sale is critical to preserve the value of your property and to ensure a secure financial future for you and your family.
There are financial tools and tax-saving strategies you can use to preserve wealth when selling your farm/ranch. In today’s complex financial world, you need a plan that takes into account tax, retirement, estate and investment planning. No single person has the expertise to effectively address each of these areas. This is why you need to work with a team of advisors. Besides the real estate agent you work with to sell your property, planning for your sale may involve the services of a CPA, Estate Planning and Real Estate Attorney, Planned Giving Specialist, 1031 Exchange Intermediary, Investment Advisor, Commercial Real Estate Agent, Real Estate Appraiser, and Insurance Agent. A team of advisors collaborating together on your behalf helps maximize the effectiveness of your plan by making sure every area is properly addressed.
Listing your property for sale
Your farm/ranch likely represents the majority of your net worth. Who you choose to list your property with is a critically important decision. Choosing the right ranch broker will not only help you obtain a top price for your property but will facilitate a smooth transaction. A good real estate agent will aggressively market your property to the right group of buyers and head off potential issues in advance. Issues, that if not identified and dealt with in the beginning, could later end up costing you money and stress. Selling a farm/ranch requires specific knowledge and expertise. It is wise to work with someone who specializes in farm and ranch sales. Someone who understands water rights, mineral rights, environmental issues, land surveys, easements, building liability etc. They should also know how to properly assess the agricultural and recreational value as well as the value of your property’s intrinsic aesthetic beauty. A good real estate agent will help you use the most current and appropriate marketing methods to create desirability for your property. They will aggressively market the listing of your property with other real estate companies versus keeping the property to themselves in hopes of collecting both the listing and buyer side commission of the sale. Some of the things to look for when selecting an agent are the agent experience and company track record. You want a company that is doing a large percentage of sales in the farm and ranch market and who has a reputation for honesty, integrity and professionalism. You want a company and agent who are well connected with the target audience for your property. It is wise to interview several agents when considering the sale of your property. These agents will usually provide a free market analysis of your property and quote you a price they would list your property for. People often list their property with the agent who quotes them the highest selling price. This may not be the best person to work with because listing your property too high can end up costing you time and money and may ultimately have a negative impact your bottom line. One way to avoid this mistake is to have an appraisal of your property prior to interviewing real estate agents. Your appraisal should be conducted by an individual that specializes in appraising farm/ranch land and has years of experience. By knowing what your property is worth up front, you can base your decision of who to hire on factors besides price. Do not show the agents your appraisal. This is something you reserve for yourself. When you have chosen whom you are going to hire, be sure to carefully read the entire property listing agreement prior to signing. If there is something you are uncertain or uncomfortable with, seek the advice of an attorney.
Taxation of farm/ranch assets
Various tax rates and tax treatment apply to the different types of assets involved with the sale of a farm or ranch. It is imperative that you and seek direction from your tax advisors when purchase price allocation is being negotiated.
Allocation of sale price
How you allocate the sales price to the assets of your ranch will determine the tax you ultimately may pay. Conflict can arise when negotiating how to allocate the sale price. You, the seller, want to pay tax at the capital gain rate because it is currently lower than ordinary income tax rates. Conversely, the buyer wants to allocate more of the sale price to depreciable assets. When a farm or ranch is purchased or sold, both the buyer and seller must report to the IRS the allocation of sales price. IRS form 8594 is titled the Asset Acquisition Statement. This form should also be attached to the buyer and seller’s federal income tax return for the year of the sale. Below is a list of asset categories and the type of tax owed on each category:
- Single-Use Property – IRC Section 1245 depreciation recapture applies.
- IRC Section 1250 Property – potential depreciation recapture may apply.
Irrigation systems, swathers, bailers, tractors, etc. IRC Section 1245 assets. Recapture of depreciation applies.
Raised livestock – breeding stock
- Cattle and horses – held greater than two years – taxed at capital gain rates
- Other livestock – held greater than one year – taxed at capital gain rates
- There is no cost basis in raised livestock
- Purchased livestock – Breeding stock
- Cattle and horses – held greater than 2 years – taxed at capital gain rates
- Other livestock – held greater than 1 year – taxed at capital gain rates
- Cost basis is purchase price. Depreciation recapture rules apply
- Purchased or raised livestock that is held for sale
- Taxed at ordinary income rates
- Inventory and supplies: crops, fertilizer, etc.
Taxed at ordinary income rates
- Ranch house
IRC Section 121 Exclusion:
- Gain does not apply to extent of any depreciation claimed after 5/6/97. IRC Section 121 (d)(6).
- No allocation of exclusion is required if both the residential and business portions of the property are with the same dwelling unit, other than to the extent the gain is attributable to depreciation after 5/6/97.
- 121 Exclusion is not eligible for homes owned in a corporation.
Below is a summary of the four ways investors may be taxed on the sale of a farm or ranch:
- Federal Ordinary Income Tax: Taxpayers will be taxed at rates up to 39.6% depending on taxable income.
- Depreciation Recapture:Taxpayers will be taxed at a rate of 25% on all depreciation recapture.
- Federal Capital Gain Taxes: Investors owe Federal capital gain taxes on the their economic gain depending upon their taxable income. Since a new higher capital gain tax rate of 20% has been added to the tax code,investors exceeding the $400,000 taxable income threshold for single filers and married couples filing jointly with over $450,000 in taxable income will be subject to the new higher tax rate. The previous Federal capital gain tax rate of 15% remains for investors below these threshold income amounts.
- New Medicare Surtax Pursuant to IRC Section 1411: The Health Care and Education Reconciliation Act of 2010 added a new 3.8% Medicare Surtax on “net investment income.” This 3.8% Medicare surtax applies to taxpayers with “net investment income” who exceed threshold income amounts of $200,000 for single filers and $250,000 for married couples filing jointly. Pursuant to IRC Section 1411, “net investment income”includes interest, dividends, capital gains, retirement income and income from partnerships (as well as other forms of “unearned income”).
- State Taxes: Taxpayers must also take into account the applicable state tax, if any, to determine their total tax owed. Some states have no state taxes at all, while other states, like California, have a 13.3% top tax rate.Montana currently has a top rate of 6.9%
Tax saving tools for selling appreciated or depreciated property
Selling highly appreciated (or depreciated) property can result in a large tax bill. Taxes due on the sale may range from 20% to over 50% of the sale price depending on the cost basis of your property and how your property is owned. Prior to listing your property, have a CPA perform a tax projection. This will be valuable information for you when considering tax-saving strategies. Two financial tools are commonly used to defer or avoid tax on the sale of highly appreciated (or depreciated) property: IRC Section 1031 Exchange and IRC Section 664 Charitable Remainder Trust (CRT). Using one or a combination of these tools with a sale will save tax. Money that would have gone to paying tax can then be invested to generate income for you and your family.
IRC Section 1031 tax-deferred exchange
The IRC Section 1031 Exchange can be a powerful tax saving and wealth building tool. It allows a taxpayer to sell property and purchase other property without currently recognizing capital gain tax on the sale. To quote the tax code: “No gain or loss shall be recognizedon the exchange of property held for productive use in a trade or business or for investment purposes if such property is exchanged solely for property of a like-kind which is to be held for either productive use in trade or business. There are specific rules and strict time frames pertaining to the identification and receipt of the replacement property for the completion of a delayed exchange.
- 45-day rule: The first time constraint, which must be satisfied, is for the investor to close on the replacement property or identify in writing the potential replacement property or properties within 45 days from the date of transfer of the relinquished property. After the 45 day identification period has lapsed, 1031 exchange rules do not allow for the further identification of potential replacement properties.
- Property Identification Rules: The number of potential replacement properties identified is subject to the following rules:
- Three Property Rule: You can identify three properties regardless of value.
- 200% Rule: You may identify any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the value of the relinquished property.
- 95% Rule: You can identify any number of properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate fair market value of all the potential replacement properties identified.
- 180-Day Rule: The replacement property must be received and the exchange completed no later than the earlier of 180 days after the transfer of the relinquished property or the due date (with extensions) of the income tax return for the year in which the exchanged property was transferred. Note that if an exchange takes place late in the tax year, the 180 day deadline can be later than the April 15 filing date of the tax return. If the exchange is not complete by the filing date, the return must be put on extension to properly extend the deadline for the full 180 days. If not put on extension, the replacement property time period will end on the filing date of the return. In other words, do not file your income tax return for the year in which you do your 1031 exchange until you complete your exchange. Be sure to seek the services of a reputable 1031 Exchange Intermediary when considering a 1031 Exchange. For more information on 1031 Exchanges, request Wealth Guide titled: IRC 1031 Tax-Deferred Exchange. To request a list of reputable 1031 Exchange Intermediaries who have extensive experience with farm and ranch exchanges, call Chris Nolt at 406-582-1264 or send an email to: email@example.com
IRC Section 664 charitable remainder trust
A charitable remainder trust (CRT), sometimes referred to as a capital gains avoidance trust, can be another powerful tool to defer or entirely avoid capital gain tax on the sale of appreciated real estate. In addition to avoiding tax on the sale of real estate, a CRT can also be used to avoid tax on the sale of other assets such as livestock, machinery and equipment. Combining a CRT and a 1031 exchange can be a powerful way to save tax, diversify investment assets and generate lifetime income.
A CRT provides many potential benefits for and agricultural family.
- It can be used to save tax on the sale of appreciated land and on the sale of livestock, machinery and equipment.
- The full sales proceeds can be invested which allows a family to generate more retirement income as opposedto investing after tax proceeds from a straightsale. • Provides a vehicle to diversify assets for retirement income.
- It may reduce or avoid estate taxes.
- It can be used to fund a life insurance policy to equalize inheritance among on and off-farm heirs.
- It can benefit one’s favorite church and/or charities.
- It can provide a lasting legacy for the donors.
How it works:
A donor establishes a CRT and then transfers assets (e.g., real estate, livestock and/or equipment) to the trust, removing the assets’ values from the donor’s estate. The trust then sells the assets and, since it is a tax-exempt entity, there are no taxes due upon the sale. The proceeds from the sale are then invested in a manner designed to provide a lifetime income for the beneficiaries. Two sets of beneficiaries are established, the income beneficiaries (generally the donor and his or her spouse), and the remainder beneficiaries (the charities that will receive the principal, or “remainder”, of the trust after the income beneficiaries die). Using a combination of a 1031 Exchange, Charitable Remainder Trust and a direct sale for cash can often be an optimal strategy for reducing income and estate taxes and providing diversification of investment assets. For more information on Charitable Remainder Trusts, request Wealth Guide titled: Charitable Remainder Trust: A Valuable Tool for the Agricultural Family.
Life insurance as an estate planning tool
Life insurance can serve many purposes for the agricultural family. Besides providing for basic family income protection, life insurance can be purchased to provide cash to pay estate taxes and other costs at death so your kids aren’t forced to sell assets to come up with the necessary cash. Estate Equalization among children is another common use of life insurance. This is most often used when parents are passing their farm/ranch to a child working on the property and want to be fair to other children not inheriting the farm/ranch. By purchasing life insurance for the off-farm heirs, they can equalize inheritance. When a Charitable Remainder Trust is used in the sale of a farm/ranch, life insurance is often purchased with income derived from the trust to replace the assets donated to the trust that ultimately pass to the charity or charities you name in the CRT.
Irrevocable Life Insurance Trust (ILIT)
There are important tax implications associated with the ownership of life insurance. The IRS states that if you have any incidents of ownership in a life insurance policy, the proceeds will be included in your estate for estate tax purposes. By properly owning your life insurance policy in an ILIT, proceeds from life insurance can be received by your kids and grandkids both income and estate tax-free. When used in conjunction with a Charitable Remainder Trust, an ILIT is often referred to as a Wealth Replacement
Trust because it replaces the wealth passed to charity through the trust. Second-to-Die life insurance (also referred to as Survivorship Life Insurance) is the most common product used for these situations. This type of insurance insures two lives under one policy with the death benefit payable upon the second death. For more information, request our Wealth Guide titled: Life Insurance: An Estate Planning Tool for the Agricultural Family.
Real estate comprised of multiple separately deeded parcels
Farms and ranches are often composed of multiple, separately deeded parcels with varying cost basis figures. This typically happens as additional parcels of property are inherited or purchased over time to expand the capacity of the farm or ranch.
If you are considering a 1031 exchange for part of the sale, a potentially effective tax-saving strategy is to obtain separate buy-sell agreements on each parcel so you can exchange the low-basis parcels and take cash out of the high basis parcels.
IRC Section 121 personal residence exclusion
IRC Section 121 allows an individual to exclude up to $250,000 of taxable gain from the sale of a principal residence and a married couple filing a joint return to exclude up to $500,000 of gain. This exclusion can only be used in conjunction with real property that has been held and used as the homeowner’s primary residence and does not apply to second homes, vacation homes, or property that has been held for rental, investment or use in a trade or business. Homeowners are required to have owned and lived in the home as their primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years) in order to qualify for the 121 exclusion. The 24 months does not have to be consecutive. To maximize the amount of tax-free cash you may receive from the sale of a farm or ranch containing the personal residence, one may include additional acreage with the home. Make sure to discuss this strategy with your real estate agent and CPA.
Owning farm/ranch real estate inside an entity
How you own your farm/ranch impacts the tax treatment and planning options available to you.| Typical entities that own farm/ranch real estate include: • General Corporation, also known as a “C” Corporation. • Subchapter S Corporation • Partnership/Limited Liability Company
Ranch owned in a C corporation
While most investors own real estate today in the name of an LLC, partnership or S Corporation, there are still those who own property in a C Corporation. A C corporation is a separate taxable entity and pays tax on profits at the corporate level. When a C corporation sells appreciated real estate, it will owe tax on the profit at the corporate tax rate. When proceeds from the sale are then distributed to the shareholders as dividends, the shareholders will also have to pay tax on this income at their personal tax rate. Consequently, due to this double taxation, it is possible that the total tax due from the sale of appreciated real estate in a C corporation could easily exceed 50%.
C Corporation 1031 exchange
One way to potentially avoid this double tax consequence is for the C Corporation to perform a 1031 exchange. While it is not normally advised to perform a 1031 exchange on the total sale value, this is one situation where it may make sense to consider an exchange on the entire amount.
Converting from C Corporation to S Corporation
Under the 1986 Tax Act, personal rates were reduced and C Corporations were permitted to convert to an S Corporations(a pass-through entity similar to a partnership),thereby avoiding the double tax. Some C Corporation shareholders never took the opportunity to convert and therefore remain subject to double taxation.A potential solution to eventually avoid the double taxation on the liquidation of real estate in a C Corporation is to convert the C Corporation to an S Corporation. In order to become an S corporation, a C corporation must file IRS Form 2553 with the IRS. This form must be signed by all shareholders, meaning that each shareholder has veto power over conversion from C Corporation to S Corporation. Approval of Form 2553 by the IRS is routine(not discretionary) as long as the corporation meets the formal eligibility requirements.
Ten-year holding period and built-in-gain tax
A holding period exists for conversions from C corporations to S corporations. This holding period is currently 10 years. If the S corporation is liquidated prior to this 10-year holding period, a Built-In-Gains (BIG) Tax may be imposed.
This tax equals the highest corporate tax rate, currently 35%. BIG Tax requires a company to measure the amount of unrecognized appreciation that existed at the time an S election is made. The BIG tax will not apply to a newly formed S corporation. If a prior C Corporation makes an S election, the company needs to measure the fair market value at the effective date of the S election as compared to the tax basis. The amount of unrecognized gain is determined for each asset. The net of unrecognized built-in gains and built-in losses is the company’s unrecognized built-in gain. The BIG Tax ends after the tenth S corporation tax year. Accordingly, you can avoid the BIG Tax if the unrecognized built in gains are not recognized until after the tenth year as an S corporation.
- No double taxation on sale of assets. Tax attributes on sale flow to the individual shareholder.
- Tax results when appreciated assets are distributed out.
Partnership/Limited Liability Company
- Tax attributes on sale of assets flow to the partnership.
- Most assets can be distributed out without resulting in taxes.
- Converting ownership from a partnership or LLC to tenants-in-common.
Sale by a family limited partnership/LLC
Many people own their property in an entity such as a family limited partnership or limited liability company (LLC). These entities enable families to receive valuation discounts for estate planning purposes. Often, interests in such entities are gifted, using the IRC Section 2503 annual exclusion gift presently set at $14,000 per person per year, to family members. Upon a sale of limited partnership-owned property, the net selling price will be distributed to partners based upon their relative ownership interests. Each item of income reported on a 1065K-1 will retain its character (recapture, capital gain, etc.), and be taxed accordingly. As most limited liability companies are taxed as limited partnerships, the above rules will similarly apply. However, one distinction in the LLC area is that, as to one’s membership interest, the income interest and the capital interest do not have to be the same. For example, one’s LLC membership interest may reflect a 20% income interest, but only a 10% capital interest. In such case, one’s share upon asset sale and distribution is governed and limited by your capital interest.
Exchanging property owned by multiple partners/shareholders
Owning appreciated real estate in an entity can create problems when it comes time to sell the property. Challenges arise if there are multiple partners/shareholders with different goals upon sale. For example, if two people own appreciated land in partnership and one partner would like to do a 1031 exchange and one partner would like to pay tax and take the after-tax proceeds, there is a problem. The IRC 1031 Exchange provisions require that the entity selling the relinquished property must be the same entity taking title to the replacement property. So in this case, the partnership would have to do the exchange and each partner could not do his or her own exchange. Fortunately, there are solutions to this problem.
- Solution 1: Drop and swap
Prior to a sale, the partnership could distribute (drop) the property out of the partnership and each partner would take title to their ownership in the property as Tenants-In-Common. This would allow each partner to then perform a 1031 exchange (swap) for their ownership in the property if they so desired. To comply with IRS rules, it is important that the distribution of the property out of the partnership take place well in advance of a sale. Please consult your CPA and/or attorney regarding this matter.
- Solution 2: Swap and drop
Using this strategy, the partners could each identify their own separate properties they wish to own. The partnership would perform the exchange (swap) and at a later date, preferably longer than one year, the partnership could distribute the property (drop) to each partner “in kind”.Once again, consult your CPA and/or attorney regarding the use of this strategy.
You’ve worked hard to create the value in your farm or ranch. Now it’s time to work smart to preserve that value. Planning in advance of the sale of your farm or ranch is critical for preserving your wealth. There can be complex financial issues involved and if not addressed prior to a sale, you stand the chance of missing opportunities to enhance your wealth. Working with a team of advisors who collaborate together on your behalf will ensure all areas are properly addressed and will help you achieve your financial goals in the most effective manner possible. There are different tax rates that apply to various assets involved in the sale of a farm/ranch. How you allocate the sale price to these different assets will impact the tax you may pay. The IRC Section 1031 Exchange can be a powerful tool for saving tax on appreciated real estate. By performing a 1031 Exchange, you can save tax and that tax savings can be used to purchase real estate that can provide you a monthly income for retirement and other purposes. The IRC Section 664 Charitable Remainder Trust (CRT) is another powerful tax saving and estate planning tool. A CRT can save you tax on not only land but on other assets such as livestock and equipment. A CRT can also be used to invest in a diversified portfolio of assets to provide you a lifetime income. In addition, a CRT can potentially save estate taxes by reducing the value of your taxable estate. Life Insurance and Irrevocable Life Insurance Trusts (ILIT) are valuable estate planning tools. Structured properly, life insurance inside of an ILIT can ensure your children and grandchildren will receive money that is free from income and estate taxes. This money can be used to replace wealth given to a CRT, to prevent children from being forced to sell assets to pay estate taxes or to equalize inheritance among children. When selling land comprised of multiple parcels with different cost basis figures it may be wise to obtain separate buy-sell agreements on each parcel. This could allow you to exchange low basis parcels and take cash out of higher basis parcels. The IRC Section 121 Personal Residence Exclusion may allow you to receive tax-free cash from the sale of your home. Allocating additional land with the sale of your home may allow you to increase the amount of tax-free cash you are able to take out of the sale. Selling farm/ranch real estate owned in an entity can present significant problems. Appreciated land owned in a C Corporation may be subject to double taxation with combined rates exceeeding 50%. IRC Section 1031 Exchange rules require the entity purchasing replacement property be the same as the entity exchanging the relinquished property. When a farm or ranch is owned in an LLC or partnership and the partners want to go their separate ways upon the sale, this can present a problem. Using a drop and swap or swap and drop strategy as explained above is one way to achieve each of the partner’s goals. If you are selling or considering selling a farm/ranch, now is the time to start the education and planning process.
Additional wealth guides related to the sale of farm or ranch include:
- Financial Strategies for Selling a Farm or Ranch
- Investing Proceeds From the Sale of a Farm or Ranch
- Interview Guide for Selecting a Ranch Broker
- Charitable Remainder Trust: A Valuable Tool for the
- Life Insurance: An Estate Planning Tool for the Agricultural
- IRC 1031 Exchange: A Powerful Tool for the Agricultural
To request these and other Wealth Guides, call Chris Nolt at 406-582-1264 or email me at firstname.lastname@example.org. For more information, visit: www.solidrockwealth.com and www.solidrockproperty.com
Chris Nolt is the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, with offices in Bozeman, Montana and Fountain Hills, Arizona. Solid Rock Wealth Management and Solid Rock Realty Advisors specialize in working with families who are selling a farm/ranch or other business and transitioning into retirement. We help our clients to save tax on the sale and to create passive income from sale proceeds. We employ a comprehensive planning approach with a team of financial professionals, which addresses retirement planning, investment planning, estate planning, tax planning, charitable giving and risk management. Our wealth preservation strategies are designed to help our clients reduce taxes increase retirement income and maximize the amount of wealth they pass on to their heirs and favorite charitable organizations.
Solid Rock Wealth Management is an independent, fee-only registered investment adviser. We offer globally diversified portfolios of no-load, low-cost institutional asset class mutual funds and exchange traded funds. Are portfolios are diversified among as many as 15 asset classes and market sectors and are comprised of holdings in roughly 12,000 companies in 45 different countries. Our model portfolios range from conservative (100% fixed income) to aggressive (100% equities) and are designed to achieve optimal returns for your level of risk tolerance. Solid Rock Realty Advisors Solid Rock Realty Advisors assists investors who are seeking secure income producing real estate investments. We specialize in office buildings leased to the U.S. Federal Government and primarily work with investors who are purchasing properties through a 1031 tax-deferred exchange. These fee-simple real estate properties offer long-term leases guaranteed by the full faith and credit of the U.S. government with competitive cap rates and professional property management.