By Andy Biebl
DTN Tax Columnist
I am 70 and winding down my farming business so sons can take over. Recently I sold $500,000 of farm equipment. What's the best way to avoid a big tax bill? Can I somehow use a 1031 exchange and put the proceeds into land with some depreciable items?
I like your creative thinking, but unfortunately the Sec. 1031 exchange rules are too narrow to accomplish your objective of machinery into land. The like-kind definitions are fairly broad for trades of real estate into other realty. But with farm machinery, we literally need to be like-kind into other property in the same depreciable class. So a trade of machinery into land, even with depreciable improvements such as barns, becomes a taxable exchange.
There's a second issue also: Your question indicates you have already sold the equipment. To accomplish an exchange, the taxpayer can't touch the cash. In an exchange, a "qualified intermediary" is engaged to handle the property sale, and to hold the cash pending identification and purchase of the like-kind replacement property.
In summary, we don't see 1031 exchanges used for the disposition of machinery by retiring farmers. Occasionally, we use a specially designed Charitable Remainder Annuity Trust (CRAT) to create a deferral. The machinery is conveyed to the Trust prior to sale, sold tax-free (due to the charitable status of the trust), followed by a term-certain payback of income to the donor. We can have up to 90% of the value of the Trust paid back to the donor, with a projected 10% residual to the charity. The concept is to spread out the taxable payments from the Trust over a period of years (any number from 3 to 20 is permissible) to get into lower tax rates. If most cases, the 10% to charity can be more than made up by a reduction in federal taxes from spreading out the payments. But it is also too late for this strategy for you, as the machinery sale would have been conducted by the CRAT.
What are the advantages/disadvantages of putting farm land in a living trust? In my case, I'm a non-resident owner of inherited parcels in Nebraska that have a cost basis dating to 1959.
A living trust is an alternative plan to a will. It provides the language for distribution of your assets after your passing, often with the same language that is found in a will. One of the advantages is you avoid the filing of probate forms in the county courthouse, meaning there are some privacy benefits. But on the negative side, there will be more legal work to transfer assets now into the trust, and then again after death. You'll need local legal counsel on these issues; costs and benefits can vary from state to state. Further, if you reside in one state and own land in another, you have special issues as to how the state estate or inheritance taxes apply to the form of land ownership.
As to that inherited land in Nebraska, I'm puzzled by your suggestion that the land has a low tax basis. That would be the case if you received the land via a lifetime gift from the prior owner (the donor's cost basis carries over in a gift). But if you inherited the land recently after the death of the prior owner, your tax cost should have "stepped up" to the fair market value at the date of death. Perhaps this inheritance was many decades ago. The tax basis doesn't affect the value for your estate planning, but it is important if you are considering a sale.
We have used equipment leases for the last 20 years. These leases have been with various implement dealers who handle different makes of equipment. The common theme is a scheduled payment either monthly or yearly, with a purchase option at the end of the term or we roll what equity as been built up between the buyout and what the equipment is worth right back into another like piece of equipment. We have deducted the lease payments as operating expense and it has worked out great for us. We have never shown these pieces of equipment on our farms balance sheet before. We only show the payments on the yearly cash flow. We use Farm Credit as our lending source and this year all of a sudden they want us to show this equipment on our balance sheet as an asset and liability. We are scratching our head some as it makes no sense because there isn't any ownership. Can you shed some light on this?
My guess is Farm Credit recognizes you have built up some equity in these leases and would like to improve the appearance of your balance sheet by reflecting that additional net worth. Legally, you may not have ownership, but substantively if the equipment value exceeds the buy-out costs, there is economic value. It is permissible to have differing treatment of leases in a financial statement compared to your tax return, so if Farm Credit adjusts your balance sheet, it isn't necessarily determinative for tax reporting.
But maybe this suggestion from your lender implies more. The paperwork with the implement dealer may say Lease at the top, but the tax law also looks to the details and substance to determine whether it is actually a lease or a financing/purchase arrangement. This might be a good occasion to seek tax advice on whether your treatment of these leases is proper. If these leases are actually financing arrangements, you might find your tax deductions accelerating, thanks to first-year depreciation incentives.
EDITOR'S NOTE: Andy Biebl is a nationally recognized CPA and tax principal who specializes in agriculture with CliftonLarsonAllen LLP in Minneapolis and New Ulm, Minnesota. He writes tax columns for DTN and its sister publication, The Progressive Farmer magazine. To submit questions for future columns, email AskAndy@dtn.com. Subscribers can always find Biebl's most recent columns in Town Hall.
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