Some of the most costly mistakes in estate planning occur when tax aspects are ignored. A good estate plan encompasses your personal wishes and goals; accomplishes good legal, estate tax, and financial outcomes; and accomplishes positive tax results. Below are some of the major income tax aspects to examine as you plan your estate.
Income tax basis
When selling an asset, you pay tax on the difference between the selling price and adjusted basis (original cost plus improvements minus depreciation) of the asset. The basis is determined when you acquire the asset.
Basis is extremely important to property holders because it determines the amount of tax they will pay on the sale of an asset.
Assets that are inherited and pass through an estate receive a new or “stepped up” basis. The stepped up basis is usually the fair market value on the date of death. This provides a strong incentive to hold low basis property until death to achieve the stepped up valuation for heirs.
General example: If you sell land for $800,000 and your adjusted basis (cost) for the land is $20,000, your taxable gain is $780,000. Now, let’s say you pass that same land on to your heirs at your death and the fair market value is $800,000 at time of death. If your heirs sell the land for $800,000, the taxable gain is $0 because of the step-up in basis.
Your basis is what you paid for the asset plus improvements minus any depreciation you have claimed on it.
Example: If you purchased a rental house for $50,000 and depreciated it for three years claiming a total of $5,000 depreciation, your adjusted basis would be $45,000.
Your basis is the fair market value or special use value assigned the asset as it passed through the estate.
Example: You inherit land from your mother that is valued in her estate at $980,000. Her basis was $40,000. Your adjusted basis is $980,000. If you sell the inherited land for $980,000 you have no capital gains tax consequences.
If you receive a gift of property, your basis is the same as the donor’s basis. It is good practice to file a gift tax Form 709 even though no gift tax is due. This process constitutes “adequate disclosure” and can eliminate future gift tax issues. Filing a gift tax return starts the three-year statute of limitations. It is during this three-year period when IRS can challenge the market valuation of a gifted asset. In the absence of a gift tax return, IRS has an unlimited amount of time where market values may be challenged.
Example: You received a gift of XYZ stock valued at $120,000 but having a basis (donor’s purchase price) of $25,000. Your basis is also $25,000. If you sell the stock for $120,000, you have a $95,000 taxable capital gain.
Installment sales
Many people report sales of property on the installment method. This allows the taxation to be spread out proportionally during the years that principal payments are made (note: in a farming context, this applies to land only).
An installment sale of machinery or livestock requires payment of all tax resulting from the total gain (from all years) of the installment agreement in the first year of sale. With respect to land sales, installment sales may be useful to keep as many dollars in lower tax brackets as possible.
Using installment reporting late in life on low basis assets may not be wise because no stepped up basis is received on installment contracts. Heirs inheriting the contract must continue to pay income taxes on the principal and interest payments as they receive them. Once property is sold under an installment contract, that property is not eligible for a step-up in basis at the date of death.
Example
You own 40 acres of land worth $208,000. You have a basis (purchase cost) of $10,000 in the land. At age 85 you sell the land to your son for $208,000 on an installment contract payable over 20 years. Your profit ratio on the amount of each principal payment that is taxable would be 95.19 percent (the $198,000 profit ÷ $208,000 sale price = 95.19 percent). You receive principal payments of $10,500 each year for 4 years. Each year you include 95.19 percent of $10,500 or $9,995 as taxable income on your tax return plus any interest received.
At age 89 you die, leaving the contract equally to your two daughters and your son. Your two daughters will continue to receive 2/3 of the $10,500 annually and must include 93.75 percent of the amount on their tax return for the remaining 16 years of the contract.
If you had kept the property in your estate and not sold it, it would have passed to your children valued at $208,000 (stepped up basis) and they would owe no tax if they sold the property for that value.
Personal residence
If you sell your farm, which includes your personal residence, consider parceling out the house sale because it qualifies for a possible exemption from tax.
Since the 1990s, homeowners can exclude from gross income up to $250,000 per individual of gain ($500,000 for joint filers). You must have owned your home and lived in it for a period of two of the past five years prior to the sale. You need not buy a replacement home to qualify for this tax exemption. These provisions apply to the personal residence only, not to land or buildings used as business property [I.R.C. § 121].
1031 like-kind exchange
Selling property outright will cause a taxable event. If you have improved land or buildings, a like-kind tax free exchange, known as an IRS Section 1031 Exchange, might be considered.
You find a person who has property that is “like-kind” to yours and work out a trade. Your tax basis follows to the new property. It is a complicated tax process, but can position the younger generation on the home farm. Using the tax-free exchange can avoid or postpone taxation of the parent’s capital gains on low basis property.
To qualify you have 45 days from the transaction to locate a like-kind property, 180 days to close the transaction for the new property, and you cannot take possession of any money exchanged as a result of the transaction. Normally, 1031 exchanges are handled by a “qualified intermediary.” This can be complicated so seek legal assistance.
The Tax Cuts and Jobs Act (TCAJ) of 2017 repealed like-kind-exchange treatment for anything other than real property. Real property is considered land and/or buildings. TCAJ effectively removed like kind treatment from personal property, meaning that you can no longer do a like kind exchange with machinery and equipment.
In other words, beginning in 2018, machinery trades are considered outright sales and the replacement property is purchased at the full market price (without any allowance for a trade-in).
Income averaging
Qualifying farmers are currently allowed to use “income averaging.” This provision allows high income from a current year to be carried back equally to utilize lower tax brackets from the three previous years. This provision can help reduce income taxes for retiring farmers. See your accountant or tax preparer.
Spread out income
In most cases, as a farmer retires and they sell off their farm business assets, a large self-employment and income tax bill may emerge depending upon the type of asset. It may be wise to plan ahead and spread the final sales over a two or three year period. Leveling out income usually results in lower taxes paid than does bunching income into one year. Depending upon circumstances, always check with your tax professional when planning to exit the business.
Capital gains
According to the Internal Revenue Service (2018), "Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, [intermediate and long-term farm assets,] personal-use items like household furnishings, and stocks or bonds held as investments. When you sell a capital asset, the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss."
For 2017, Federal Capital Gains tax rates were:
- 0 percent for individuals in the 10 and 15 percent federal income tax brackets,
- 15 percent capital gains rate for individuals in the 25 percent though the top of the 35 percent income tax bracket, and
- 20 percent capital gains rate on individuals in the 39.6 percent income tax bracket.
The Tax Cuts and Jobs Act of 2017 essentially set the existing capital gains rates at 2017 levels. The breaks between the 0, 15 and 20 percent capital gains rates are no longer tied to the income tax brackets. The capital gains rates are now annually indexed for inflation. In 2018, federal capital gains tax rates are 0, 15, 20, 25 and 28 percent.
Items that qualify for capital gains treatment at the 0, 15 or 20 percent level include stocks, bonds, and land held longer than one year, as well as some raised breeding stock. Farm building sales (unrecaptured Sec. 1250 gain) are taxed at 25 percent and collectibles at 28 percent. See Figure 1: 2018 capital gains rates.
Figure 1: 2018 capital gains rates [Code Sec. 1(h)(1), as amended by Act Sec. 11001(a)(5)]
| Capital gains rate | Joint filers and surviving spouses | Head of household | Single | Married filing separate | Estates and trusts | |
|---|---|---|---|---|---|---|
| 0% | < | $ 77,200 | $ 51,700 | $ 38,600 | $ 38,600 | $ 2,600 |
| 15% | $ 77,200 - $ 479,000 | $ 51,700 - $ 452,400 | $ 38,600 - $ 425,800 | $ 38,600 - $ 239,500 | $ 2,600 - $ 12,700 | |
| 20% | ≥ | $ 479,000 | $ 452,400 | $ 425,800 | $ 239,500 | $ 12,700 |
In Minnesota, capital gains are taxed as ordinary income at rates of 5.35, 7.05, 7.85 and 9.85 percent.
Note: Sales of capital assets may be subject to Net-Income Investment Tax (NIIT). Consult with your accountant and attorney for the best strategy for minimizing the tax consequence of any transaction, and to see if the rules or rate have changed. Careful transfer planning may enable use of the lower tax rates available on capital assets. For example, sales of capital assets may not be subject to any self-employment tax.
Estate taxes
The Tax Cuts and Jobs Act of 2017 set the estate and gift lifetime exclusion amount at $10 million, indexed for inflation. For example, with the inflation adjustment, in 2018 every person has a federal lifetime gift exclusion that will offset (1) gifts of up to $11.2 million, (2) distribution of estate assets at death of up to $11.2 million, or (3) a combination of gifting and estate distribution of up to $11.2 million. Notice the word use of the word “or.” You only have one combined gift and estate exclusion, not multiple. The exclusion has portability, meaning whatever is not used by a spouse is transferable to the surviving spouse with the proper IRS paperwork. The increases in the estate and gift lifetime exclusion amount sunset in 2025.
In Minnesota, individuals that qualify for The Qualified Small Business Property or Qualified Farm Property Exclusion, may be able to transfer through their estate a maximum of up to $5,000,000 at death. This represents a combination of the Personal Exclusion amount with the Qualified Property Exclusion. Minnesota does not have a gift tax; however, gifts given during the three years prior to death are added back to the total estate value when calculating if tax is due.
Tax code complexity
Each provision of the tax code listed above is very complex. When planning your estate and farm business transfer, seek good tax and legal advice. Bad decisions can be costly. Any of these tax rules and rates can change due to state and federal legislative action.
A case study
Sally Smith sold 160 acres of farmland for $6,000 per acre or $960,000. It had a basis of $100,000. Her taxable gain (whether sold for cash or by installment method) is $860,000. Because of the sale, either she or her heirs must pay capital gains tax on the $860,000 gain. If Sally had retained the property until her death, the estate would assign a stepped up basis of $960,000 (FMV). The heirs could then sell the property for that amount and pay no capital gains tax.
Caution: This publication is offered as educational information. It does not offer legal advice. If you have questions on this information, contact an attorney.
Reviewed in 2018