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.
1031 Exchange
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.
| State | Rate | Tax | Total |
| Alabama | 5.00 | 43,750 | 175,000 |
| California | 9.55 | 83,563 | 214,813 |
| Iowa | 8.98 | 78,575 | 209,825 |
| Kansas | 6.45 | 56,438 | 187,688 |
| Kentucky | 6.00 | 52,500 | 183,750 |
| Montana | 6.90 | 60,375 | 191,625 |
| Nebraska | 6.84 | 59,850 | 191,100 |
| Texas | 0.00 | 0.00 | 131,250 |
| West Virginia | 6.50 | 56,875 | 188,125 |
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.
Risks
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.
This content may not be used or reproduced in any manner whatsoever, in part or in whole, without written permission of LANDTHINK. Use of this content without permission is a violation of federal copyright law. The articles, posts, comments, opinions and information provided by LANDTHINK are for informational and research purposes only and DOES NOT substitute or coincide with the advice of an attorney, accountant, real estate broker or any other licensed real estate professional. LANDTHINK strongly advises visitors and readers to seek their own professional guidance and advice related to buying, investing in or selling real estate.
Andy, thanks for writing this article. I have been curious to see how landowners are going to react to the increase in capital gains taxes next year. I don’t know if we will see the spicket for sales shut off or if people will embrace the new normal and move on. One thing is for certain, the 1031 Exchange will certainly be more discussed in the future. Thanks again.
Congratulations Jonathan on your recognition as LandThink Contributor of the Year. I enjoy your articles and appreciate your effort.
I believe landowners will accept the increase in capital gains tax and realize that with a 1031 exchange the gain can be deferred. The gain obligation does not go away, it is deferred until the replacement property is sold. The gain can once again be deferred in a 1031 exchange.
What is interesting is whether or not the IRS will allow the deferral of the additional 3.8 percent Medicare Contribution capital gain tax increase for taxpayers with Modified Adjusted Gross Income (MAGI) above $250,000 for marrieds and $200,000 for others. No regulations have been provided yet.
A RE Agent friend of mine had multiple sales pending, one of which was for over 1 million USD, that were dependent on the election results. With concerns over higher taxes after this election, all of these pending buyers have opted out which is a blow for them and the downstream economy. I believe some of the buyers were considering repatriating some of their holdings so the 1031 exchange would not apply here.
Mary, thank you for your comments. It will take time for the tax consequences to settle. The outcome will have an impact on 1031 exchanges. I would like to think that the farmland sale would have stood on it’s own merits based on cash flow and future value rather than the election.
As Andy mentioned, if a 1031 is not appropriate or can’t be completed, a Deferred Sales Trust may be an option and will still allow both the client and the broker to be “in the game” to buy more real estate if they choose to do so.
And don’t forget that when selling a property and choosing to pay the capital gains and other taxes upfront, a red flag may be raised for the alternative minimum tax and that is something that Andy may be able to provide advice about in advance.
Andy, great article, 2013 and beyond will be a challenge but there are still opportunities to sell highly appreciated properties with proper planning.
Thank you David for your input.
There can also be local tax in form of rollback tax from change of agricultural use to another use that triggers back tax difference in the two.
Thanks George for the heads up. What is the name of the rollback tax?
Andy – To re-iterate everyone else comments, I greatly appreciate the simplicity of your article.
Here’s my situation (1) I’m preparing to sell a farm in Missouri (2) I’d like to take those proceeds and invest in rental properties. The land has been owned for multiple years and would definitely fall under ‘Capital Gains.’
Please advise on what I should research to understand what potential taxes may apply to the selling and reinvesting of funds. Thank You!
A belated response. Best to seek counsel from your CPA as to the tax consequences. Exchange funds can be reinvested into any real property held for investment or business.
Actually, I have a question concerning the sale of farm land. The gain on the farm land has generated Net Investment Income Tax and I just don’t understand. Is farm income considered an investment, isn’t is passive income and therefore not liable NIIT?
I suggest asking your CPA the tax consequences of your sale. Given the property has been held for at least one year and a day, then long term capital gains are triggered upon sale.
If the land has been in the family since the Republic of Texas, and is sold, what is the original price to calculate?
This seems to be the default response, but it is best to ask your CPA. Market comparables would be once source if records of similar type properties can be located. Perhaps the original deed may reflect the purchase price but then the deed if located is most likely in a museum or lock box. You could try the Clerk of Court in the County where the property is located.