Landowners Brace for Stealth Tax
DTN Tax Columnist Andy Biebl is a CPA and tax partner with the accounting firm of CliftonLarsonAllen in New Ulm and Minneapolis, Minn., and a national authority on agricultural taxation. His monthly features also appear in our sister publication, The Progressive Farmer magazine. To pose questions for upcoming columns on DTN, email AskAndy@dtn.com
I read your article about the new 3.8% tax on net investment income coming in 2013. You indicated that gain from land that has been actively operated prior to sale is exempt. But landlords who collect rent — or those who haven’t farmed the land for over five years — pay the tax. Can you provide more information on this?
As of this writing, all we have for guidance is the language in the statute. The law says that investment income subject to the 3.8% tax includes gains from the sale of property, other than gains attributable to an active business. There is a cross-reference in the statute to the Section 469 passive activity rules which will be used to determine what is an active business gain exempt from the tax vs. passive income or gains that are subject to the tax.
Landlord rental activities are passive, so an individual selling land that has been in rental status would be subject to the 3.8% tax on both rental net income and any gain from the sale of the land. But if that landlord had actively farmed the property in any five out of the 10 prior years, the land should still be characterized as active business property and the gain on sale would be exempt from the 3.8% tax. But stay tuned; the IRS is expected to issue regulations to provide guidance on points such as this soon, and my interpretation of how Congress drafted this statute may not be the same as theirs.
There are several other aspects to consider regarding this looming tax. The 3.8% investment income tax is part of the 2010 Health Care legislation, and the Supreme Court will soon rule on whether some or all of that legislation survives. And, as everyone knows, the capital gain rate for 2013 and after is up for consideration again in Congress. If a landlord who would face this 3.8% tax is considering a sale of land, closing the deal in 2012 guarantees a 15% capital gain rate. 2013 and after is a big question mark.
In your article on planning for the new investment income tax, you did not mention the Section 1031 deferred exchange as a tool for tax deferral, or even tax avoidance if the land is held until death. Using a Section 1031 exchange to reinvest in other property would eliminate the 3.8% tax, right?
Yes, a Section 1031 exchange defers the gain not only for regular income tax purposes, but also for the new 3.8% investment income tax. And the phrasing in your questions is accurate: The gain is simply deferred, because your tax cost in the old property carries into the new property. If you should later sell the replacement real estate, capital gains and the 3.8% investment tax would catch up to that deferred gain. But if the replacement property is held through an estate, it receives a fresh tax cost equal to the fair market value at death; the pre-death appreciation is never subject to income tax or the 3.8% tax. Clearly, as capital gain rates increase via this new 3.8% tax, Section 1031 exchanges will have more benefit.
In one of your previous articles, you stated that in agriculture all assets are eligible for the bonus depreciation deduction. What effect does this have on center pivot irrigation and a well purchased in either 2011 or 2012? Do I still depreciate over the life expectancy of the system?
Bonus depreciation applies to new assets (as opposed to used items), but is limited to property that has a 20-year or less recovery period in the IRS classification system. Fortunately, all assets used in agriculture are classified at 20 years or less, and that is what I meant by all farming assets having eligibility. If your center pivot system is new, and of course drilling a well creates new property, both assets are eligible for the first-year bonus deduction.
If completed and placed in service in 2011, you can claim an immediate 100% deduction. If it’s 2012, the bonus depreciation is 50%, and in 2013 this incentive is gone. So if the asset is placed in service in 2012, you would immediately deduct 50% of the cost, and the other 50% would be depreciated over the IRS-designated depreciable life. For the irrigation system, that is seven years and for the well it is 15 years. Finally, you can elect to decline the bonus depreciation if it would create a deduction that is too large for your income. But the election to decline must be made for all assets in one or more depreciable life categories (i.e., for all seven-year property, all 15-year property, etc.).