By Andy Biebl, DTN Tax Columnist
I have a current landlord that inherited acreage in September 2014, but now is considering selling, possibly by public auction. Recent land auctions have sold at more than $10,000/acre. Are capital gain taxes calculated differently with inheritance? I was hoping to approach the landlord with the benefit of a private contract sale — savings on their taxes, no auctioneer commission, etc. I would like to purchase private treaty, since I’ve farmed this property for more than 40 years.
When property passes from a decedent, its tax basis is adjusted to the fair market value (FMV) of the property as of the date of death. This is known as the “step-up in basis” rule, although technically property does step-down in basis if the decedent’s tax basis happens to exceed the FMV at date of death.
This adjustment of the tax basis to FMV occurs regardless of whether the decedent’s estate was required to file an estate tax return or incur any federal or state estate tax. Further, if there is a small gain when the heirs sell the property, the long-term capital gain rates apply even though the property may have been held less than 12 months.
In the situation you describe, assuming the decedent held 100% of the property, the heir or heirs can sell with modest capital gain tax if the sale price is close to the appraised value of the property at date of death. To illustrate, let’s assume the appraised FMV as of the September 2014 date of death was $9,500 per acre, and the estate or heirs sell the property in February 2016 for $10,500 per acre.
In this example, there is only $1,000 per acre of long-term capital gain. If this is only a 40- or 80-acre parcel, there is probably little need to stretch out the gain to minimize the capital gain and net investment income tax costs.
On the other hand, if this is 500 acres and in my illustration there is a $500,000 gain, an installment sale could be very helpful in avoiding both the higher 20% capital gain rate and the 3.8% net investment income (NII) tax. In rough numbers (using the unmarried filing status), the upper-tier 20% capital gain rate only applies to tax returns with over $400,000 of total income, while the 3.8% NII tax does not apply until tax return income exceeds $200,000.
Depending on the magnitude of other income in the seller’s 1040, it is possible that an installment sale, spreading the gain over a number of years, could allow the federal tax cost to be limited to the 15% capital gain rate. This avoids the extra 5% capital gain rate and the 3.8% NII tax.
If this is a small parcel and the seller is not motivated to use an installment contract for tax reasons, a private sale to you under installment terms may have a different advantage to the seller. In a cash sale, whether through an auction or to you, the seller faces a difficult stock and bond market in terms of putting the new liquidity to work. But a seller-financed installment sale at a 4% rate or so may be attractive to them. They lock in a favorable investment rate of return, and are well-secured with their collateral interest in the farm property.
Another possibility is that the landlord did not get a full step-up in basis from the September 2014 death because the real estate was not owned by that decedent. For example, assume this farm parcel came from the landlord’s parents, and that dad had died in 2000 and it was mom’s recent death that occurred in 2014.
If dad did not fully transfer title to mom, but rather gave her only a life estate (income interest) with remainder to the child/landlord, the property was not officially in mom’s estate; she held only an income interest. In that case, the step-up in basis goes back to dad’s estate in 2000, not mom’s estate in 2014. Or perhaps 50% of the property was held by dad’s estate and mom’s more recent estate held only 50% of the land outright; half of the land had its basis adjusted in 2000 and the other half in 2014.
You certainly have some opportunity to work with this landlord to structure an installment sale that is beneficial to the seller in terms of both tax savings and investment yield, but it will take some artful tax planning on the seller’s side to optimize the seller’s results. If you are willing to structure your purchase terms to fit the seller’s needs, you should own the farm!