“This Post Has Not Been Updated to Include Changes from the “Tax Cuts and Job Act” passed on December 22, 2017.”
If you're keeping up with the series on farm taxes and buying and selling farmland, in last week's post, part 2 of 4 in the series, we discussed what qualifies as real property in the blog article titled "Farm Taxes - Property Types and Asset Classes." This week, we take a look at capital gains in tax law, the types of assets that fall under its rules, as well as investment properties, farm equipment, farm-use buildings, and other depreciable assets.
What are Capital Gains?
Capital gains are an often misunderstood and vital part of tax law. Essentially, capital gain income is investment income. Long-term capital gains are taxed at a preferred rate, less than regular income (short-term capital gains are taxed as regular income). The flip side of this is that capital losses are also treated differently, and there is a lesser tax benefit than a regular loss.
First, let’s discuss the types of assets that fall under capital gains rules. People most commonly associate capital gains with stock trades, and stocks are the most common asset to be taxed at the preferred rate as well as being easiest to explain. When a stock is purchased, there is no reduction in income because it is considered an investment. Changes in value to the positive or the negative are irrelevant until the stock is sold. At the point of the sale, the gain or loss is figured from the sale price less certain costs of the sale, minus basis. We will discuss basis in more detail later in this series, but basis is essentially the amount paid for an asset.
Unimproved land is treated as investment property, essentially the same as a stock. At the time it is purchased, it is not depreciated as other farm assets are. As land prices rise and fall, no gain or loss is measured. Only the sale or transfer of the land can trigger tax reporting. Buildings not used for business may also be considered investment property, but that is very unusual in agriculture. When land is sold, we take the sale price and subtract the basis to get the amount of the gain or loss.
When the sale is reported on the return, it is reported with other income on the return but the tax is figured in a different way. Capital gains tax has fewer brackets than marginal brackets and the tax is always below the marginal rate – 0%, 15%, or 20% - with exceptions for collectibles and certain real property that has been subject to accelerated depreciation. (Note that there is currently a Net Investment Income Tax on high earners that potentially adds an additional 3.8% tax on some or all of the gain, making the total tax on the gain higher the capital gain rate. That tax may be repealed as Congress debates replacing the Affordable Care Act.)
Farm Equipment and Buildings
Equipment, farm-use buildings, and other depreciable assets are, in a way, considered to be part business use and part investment. If you purchase a combine and are depreciating it over seven years, but sell the combine in year four, the sale will involve both capital gain and ordinary income, as a portion of the sale will likely include depreciation recapture. It is important to be aware of those issues, especially in this context relating to the sale of farm buildings.
The Farm Tax Experts at AgriSoltions Can Help
Understanding the allocation of capital gains versus ordinary income can ensure your results are properly reported on your return and taxes are minimized according to the law. We can help you make informed decisions if you work with us in advance of the transaction. We can work across your 1040, from farm assets to stock portfolios to other business or collectible assets. We can also work across years to offer long-term options based on your overall strategy and goals. We can discuss options with your financial advisor at your request. It is always beneficial to share general information on the breadth of your investments, even if you don’t share detailed information each year.
Properly applying tax law could mean lower taxes for farmers. Let us take a look at your return to make sure you’ve taken all of the available deductions, credits and extra options available for farmers.