Tax considerations when transferring assets
- Transferring assets must be well thought out and implemented carefully because of the potential financial consequences.
- Work with an attorney to get information on your specific situation.
There are numerous tax related aspects to consider when transferring assets. Some tax aspects are related to your yearly income, whereas other tax implications impact your overall estate. First we discuss tax basis and then delve deeper into other tax related transfer issues.
Income tax basis
Basis is the amount of capital in a property at acquisition recognized for tax purposes. When selling an asset, you pay tax on the difference between the selling price and your adjusted basis (cost plus improvements minus depreciation) of the asset.
Example: If you sell land for $100,000 and your adjusted basis for the land is $20,000, your taxable gain is $80,000.
The adjusted basis is determined by how you acquired the asset.
If you purchased the asset
Generally, your basis is what you paid for the asset, plus improvements, minus any depreciation you've claimed on the asset.
Examples: 1) If you purchase a tractor for $120,000 and depreciated it for three years claiming a total of $42,850 depreciation, your adjusted basis would be $77,150 (assuming no improvements).
2) If you purchased land and have claimed no depreciation on it, your basis is what you paid for it, plus any improvements (tiling, etc.).
If you inherited an asset
Your basis is the fair market value (FMV) or special use value assigned the asset as it passed through the estate to you.
Example: You inherited some land from your mother. Her adjusted basis was $70,000. Upon her death, the land received a step up in basis and is valued in her estate at $160,000. Your adjusted or cost basis is $160,000.
If you received an asset as a gift
Generally, your basis is the same as the adjusted basis of the donor.
Example: You received a gift of farmland valued at $160,000 with a basis (purchase price) to the donor of $25,000. Your basis is then $25,000.
Asset basis is extremely important to the property holder since it determines the amount of tax that will be paid upon the sale of the asset.
Assets that pass through an estate receive a "stepped up" basis. The "stepped up" basis is usually the fair market value on the deceased individual's date of death. This provides a strong incentive to hold low basis property until death to achieve the stepped up valuation for heirs.
Example: Sally Smith sold 160 acres of farmland for $4,200/acre or $672,000. It had an adjusted basis of $100,000. Her taxable gain whether sold for cash or by installment method would be $572,000. Because of the sale, she or her heirs must pay tax on the $572,000 gain. However, if Sally had retained the property until her death, the estate would assign a stepped up basis to FMV of $672,000. The heirs could later sell the property for that amount and pay no tax.
Other tax situations and considerations
If you sell your farm, which includes your personal residence, up to $250,000 per individual ($500,000 for married filing jointly) of the gain on the residence portion may be excluded from taxation. To qualify for the full exclusion, you must have owned and occupied the residence for at least two out of the five years before the sale. Property held under two years may qualify for a partial exclusion under certain conditions.
Rural residence and ag land both qualify for the Minnesota homestead classification. Rural residence includes the home, garage and one acre of property. For ag land only, qualifying owners who live on the farm or in the house on the farm can receive reduced real estate tax payments due to Minnesota homestead classification. Farm owners who have a qualified family member operating their farm may qualify for a double homestead classification - one on their personal residence and a second on the farm. Distance limits as well as dollar and acre limits apply to the designation.
If you place your land and buildings, previously classified as homestead, into a trust or any of the other Minnesota business entities, you will have to reapply for homestead classification. Maintaining homestead classification until death is one of the criteria for qualifying for the MN estate tax exclusion on qualified small business property qualified farm property.
For more specific details on this issue see maintaining farm land homestead classification and qualification. Homestead classification can be a very complicated and nuanced issue, especially when business entities such as corporations are involved. Check with your county assessor for more details. They have final say on homestead classification.
Many farmers opt to report sales of property on the installment method. This allows the taxation to be spread out proportionally over the years that principal payments are made. This option may be useful to keep as many dollars in the lower tax brackets as possible.
Using installment reporting late in life on low basis assets may not be wise since no stepped up basis is received on installment contracts. Heirs must continue to pay the income taxes on principal and interest payments when the asset passes to them.
Most items can be sold using the installment method. Any gain, to the extent of depreciation on equipment and all other Sec. 1245 property as well as depreciable business property sold to related parties, will not qualify for installment tax treatment.
If the entering generation owns tradable property, a like-kind tax-free exchange might be used to transfer farmland or buildings. This is a complicated tax issue but can aid in moving the younger generation onto the home farm. Using the tax free exchange can avoid or postpone taxation of the parents' capital gains on low basis property. Rules for IRS 1031 state that you have 45 days to locate a like-kind piece of property, 180 days to close the transaction, and you cannot take possession of any funds that are involved - the funds must go through an intermediary such as a realtor.
Caution: make sure your attorney and accountant communicate regarding this type of transaction so no detail is overlooked. Non-compliance can result in forfeiture of the transaction and tax consequences.
As a farmer retires and sells off his or her assets, a large income and self-employment tax bill emerges. It may be wise to plan ahead and spread the final sales over a two, three or more year period. Leveling income usually results in lower taxes paid compared to bunching income into one year.
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.
Income averaging allows farmers to spread their income in a high income year over the past three years which may have been lower income years. This can significantly reduce taxes paid in a high-income year. Income averaging does not affect self-employment tax on either the current or previous years. Income averaging applies to ordinary (Schedule F, Form 1040) farm income as well as gain from the sale of assets used in the farming business except from the sale of land or timber. It also applies to an owner’s share of net farm income from an S corporation, partnership, or limited liability company and wages received by an S corporation shareholder from the S corporation.
If you have contributed to the Social Security (SS) system at a high level during your lifetime, you may be considering retirement before your full retirement age (FRA) to begin drawing SS benefits. This would result in a reduced monthly benefit compared to retiring at your FRA. However, it might take many years of higher benefits to offset drawing reduced benefits for several additional years. In addition, farmland rental income is not subject to SS taxes. Not retiring early could cost you more per year due to not collecting monthly benefits and having to pay added tax on SE income.
However, if you have contributed to SS on a low level of earnings during your lifetime, it may be advantageous to delay retiring until your FRA. Hopefully during these last few years you can build your benefit package by making larger contributions to SS. High earnings and high contributions could have a significantly positive effect on your Social Security benefits.
This is a complicated issue but also a crucial issue to you and your farm business transfer and retirement planning. Seek advice from a qualified Social Security representative.
As a result of passage of the 2010 Affordable Health Care Act (ACA), there are additional Medicare taxes that will apply to higher income individuals. These taxes could affect someone liquidating land, machinery or other farm assets depending upon their situation. Tax income threshold amounts are as follows:
Married filing jointly - $250,000
Married filing separately - $125,000
Single - $200,000
Head of household - $200,000
The tax increases apply to earned/active income and unearned/passive income. The thresholds are not indexed for inflation.
For those above the thresholds listed above, there is an additional 0.9 percent tax in addition to the existing 2.9 percent Medicare tax. That will result in a total maximum tax rate 3.8 percent. The increase applies to earned/active income which includes self-employed income, farming wages as well as non-farm income.
Income is classified as earned/active income if the income is from farming or a business where the farmer/owner has material participation. There are several criteria for determining if the farmer has qualified for material participation.
Material participation criteria include:
More than 500 hours spent participating in the farm business.
Farmer’s participation in farming activity represented substantially all of the total participation of all persons who participate.
Farmer participated more than 100 hours and more than anyone else in the activity for the year.
Farmer participated on a regular and continual basis during the year based on all facts and circumstances.
If done regularly and continuously, a farmer who makes independent management decisions for the farm is generally considered to materially participate (crop rotation, buy or sell grain, manage labor, etc.).
Participation of the farmer’s spouse will count toward material participation in the business.
Material participation must be determined each and every year. If material participation is met and the taxpayer’s income is above the applicable threshold amount, the amount above the threshold amount is subject to the additional 0.9 percent Medicare tax. If the taxpayer’s income is not above the threshold amount, their income is not subject to the additional 0.9 percent Medicare tax.
If you are above the thresholds above and do not materially participate in a farm or business, you will have an extra unearned or passive income tax. The tax rate is 3.8 percent for amounts over the threshold amounts. This tax is imposed upon what the law refers to as new investment income for certain individuals, estates and trusts. Threshold amounts are the same as listed earlier in this section.
Net investment income includes the following:
Gross income from interest, dividends, annuities, royalties and rents.
Gross income derived from businesses that are passive activities (includes land rent).
Gross income derived from businesses trading financial instruments or commodities.
Net income from disposition of property taken into account in computing taxable income (net capital gain from the sale of property or assets, including farm assets, if not used in trade or business). This could affect someone selling land.
A passive activity is a trade or business where you do not materially participate. For example, you no longer farm but rent your land to your son, daughter, or a neighbor. This is a passive activity. Another example is if you owned a hardware store with an apartment above the store. You rented the business and the apartment to your niece or nephew and collected rent from them. This is also a passive activity. The only way renting the store and apartment would not be a passive activity is if you were in the real estate rental business - that would qualify the income as earned/active income because you were conducting your real estate rental business.
With regard to passive income, there is an exception for farmers. A farmer who materially participated in the farm operation for five years in the eight-year period before the farmer begins to draw Social Security are exempt from the 3.8 percent surtax on the sale of farm assets.
One additional issue is that capital gain from the sale or liquidation of a closely held C corporation, even though the taxpayer may have materially participated, is subject to the 3.8 percent Medicare surtax. Because this is a complicated area and this can affect farmers selling farm assets, check with your attorney or accountant for information specific to your situation.
Note: With changes in federal governmental elected officials these laws can change quickly. Make sure you check with your attorney and accountant for up to date information or information specific to your situation!
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