When selling land, whether farmland, timberland or raw land, federal and state taxes are triggered and due in the year following the sale. The sale proceeds are reported on the taxpayer’s federal and state tax return. If the property sold for a value greater than the purchase price, then a capital gains tax is due. The capital gains tax is currently 15 percent given the property has been owned for at least a year and a day and the taxpayer is in the 25 percent tax bracket and above. If owned for a shorter period, then the short term rate or the ordinary income tax, is imposed. Recaptured depreciation is not due given land cannot be depreciated.
If the intent when selling is to acquire a replacement property, then the taxpayer should consider a 1031 exchange that allows the gain to be deferred indefinitely or until the replacement property is sold. Another 1031 exchange can be initiated as often as needed. The tax obligation does not go away, but is postponed. The 1031 exchange theory is that given the replacement property is of equal or greater value than the old or relinquished property, the taxpayer’s economic position has not changed. No benefit has been received by reinvesting the net equity and equal amount of retired debt if any in the replacement property. The tax deferral can be sizable.
Potential Total Capital Gains
Imagine a 300 acre farm acquired for $1,500 per acre or $450,000 and held for seven years is now sold for $5,000 per acre or $1,500,000. With selling expenses of $175,000, the federal capital gains tax is $131,250. Depending upon which state the property is located, a five figure state capital gains tax might also be added.
The numbers above are based on the current 15 percent long term capital gains tax which is scheduled to sunset or increase to 23.8 percent January 2, 2013 for income earners above $200,000.
By deferring the gain, one risk is that the tax rate will be higher when the property is eventually sold. Estate planning is required to understand if the property is conveyed to the taxpayer’s beneficiaries at death, the tax could rate could be 35 percent on the value above the current federal estate tax ceiling of $5.12 million.
Another risk could be that the replacement property does not appreciate in value or provide the intended cash flow requiring deferred maintenance. Care must be taken to understand the replacement property condition and on-going requirements.
Deferred Sales Trust
A deferred sales trust (DST) is an option that does not require the acquisition of a replacement property. The sale occurs as normal with a trust receiving the proceeds that are invested over a horizon and investment strategy determined by the taxpayer and his/her financial advisors.
Selling real property especially a farm or land that has been in a family for generations, is not easy. Seek the guidance of a trusted financial advisor or estate tax attorney to explore the options including a 1031 exchange.