The kids have grown, the company no longer uses the property as a retreat, the taxpayers want to downsize or the price offered represent a number of reasons why taxpayers decide to sell their ranch. When selling, taxpayers want to know what the tax implications are, if the capital gains taxes can be deferred, and what planning steps are required.
Two Tax Deferral Strategies
The tax implications of selling a ranch can represent upwards of 40 percent of the sales price. The state capital gains rate varies by state – the California state capital gains rate is 9.55 percent, while in Montana, it is 6.9 percent. Federal long term capital gains is 15 percent, scheduled to sunset to 20 percent on January 1, 2013 in addition to a 3.8 percent health care tax on individuals whose income is greater than $250,000 per year. Add a 25 percent recaptured depreciation on real property improvements regardless of bonus depreciation and the taxes add up, making a tax deferral strategy a “must have.”
If the taxpayer’s intent is to replace the real property, then a 1031 tax deferred exchange may be the best tax deferral strategy. In a 1031 exchange, real property can be exchanged for any real property as long as both old and new are located in the United States. The debt and equity in the old or relinquished property must be equal to or greater in the replacement property. Personal property must be exchanged for “like-kind” or “like class” personal property, or in other words a tractor for tractor, stallion for stallion, or bull for bull.
A 1031 exchange indefinitely defers the federal, state capital gains and recaptured depreciation taxes until the replacement property is sold. 1031 exchanges can then be initiated as often as needed. Real property can be exchanged separately from personal property. To learn more about agricultural 1031 exchanges, download a complimentary whitepaper on 1031 Benefits for Farmers and Ranchers.
Deferred Sales Trust
If the taxpayer’s intent is not to replace those eligible 1031 exchange properties, a Deferred Sales Trust (DST) allows the capital gain and non accelerated depreciation recapture to be deferred. The DST invests the net proceeds of the sale into marketable securities and annuities whose income is paid out per a schedule determined by the taxpayer. The capital gains can be paid as a balloon payment or incrementally over the year consequently triggering capital gains tax on the portion received. The trustee is usually Hocking, Denton and Palmquist, a well established CPA firm in California experienced with administering this type of trust. For a complimentary illustration, complete the questions to right found on the DST page.
Eligible Real and Personal Property
The ranch is made up of real and personal property. The real property is the land, buildings, grazing rights, fixed irrigation headers and water and mineral rights, assuming the state recognizes water and mineral rights as real property. Personal property is the agricultural equipment and livestock.
- Is the ranch house considered a second home, primary residence or an investment property held for the production of income in a trade or business?
- Is the taxpayer’s intent to acquire replacement property?
If the ranch house is not the primary residence and personal use is limited to no more than fourteen overnights per year, the home is 1031 eligible. If the ranch house is considered and treated as a second home for federal tax purposes, the capital gains taxes can be deferred in a Deferred Sales Trust.
If the ranch house is the primary residence, then Section 121 of the Internal Revenue Code provides a $250,000 and $500,000 capital gain exclusion. If the capital gain exceeds the exclusion, the Deferred Sales Trust can defer the excess.
Investigating and understanding tax deferral options is the first step. It may make sense to sell the current primary residence and convert the character of the ranch house to your primary residence to make use of the Section 121 capital gain exclusion again after meeting the IRS requirements.
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