After selling your farm, if you make a profit, this profit can be either ordinary income or capital gain, depending on what type of property it is, according to IRS guidelines. You'll follow a flow chart of sorts to determine the type of property you're selling before you know whether your profit is capital gain or ordinary income. The IRS defines different classifications of property that apply to farmland, including Sections 1231, 1245 and 1252. When in doubt, consult with a tax professional regarding the sale of your farmland.
Whether or not the sale of your farm land will be taxed as ordinary income or capital gains will depend on the specific element of your property in question as well as the amount of money you gained or lost during the year.
Section 1231 Properties
The IRS defines Section 1231 transactions as real or depreciable property that you use in your business, which you've had for more than one year. If you have a farm, Section 1231 transactions include not only the farmland itself but other property, such as unharvested crops and livestock. First, you'll combine all your Section 1231 profits and losses for the tax year. If the total is a net gain (you're in the black, not in the red), it's considered ordinary income up to the amount of your total nonrecaptured losses from the previous five years.
If your net gain exceeds the amount of total nonrecaptured losses, you can carry over the excess as a long-term capital gain that offsets future losses from Section 1231 properties. If you have not held the property for one year, your total gain is considered ordinary income.
Other Section 1231 Considerations
Nonrecaptured Section 1231 losses are the total net Section 1231 losses from the past five years that have not been applied to your total net Section 1231 gains. Chapter 9 of IRS Publication 225 provides more details.
If your property qualifies as a Section 1231 transaction, you also need to determine whether any or all of the profit from its sale is considered ordinary income under the IRS depreciation recapture rules, which are explained in Chapter 3 of IRS Publication 544. Any remaining profit – whether partial or total – that does not fall under depreciation recapture rules is considered a capital gain.
Section 1245 Properties
Section 1245 covers many types of properties, which are fully detailed in IRS Publication 544. For example, these types of properties do not include most buildings, including barns, but they do include silos and grain storage bins.
The profit from Section 1245 properties is considered ordinary income, defined by the IRS as the lesser amount of 1) the depreciation and amortization allowed or allowable on the property or 2) the gain realized from the disposition of the property, which is the total disposition minus the property's adjusted basis.
Section 1252 Properties
Farmland that you've held for more than one year but less than 10 years, on which you had allowable deductions for soil and water conservation expenses, is classified as Section 1252 property. (Chapter 5 in IRS Publication 225 outlines the requirements for Section 1252 properties.) For these types of properties, part of your profit is considered gain and part is considered ordinary income.
Ordinary income represents the lesser of a) your gain or b) your allowable deductions for soil and water conservation expenses multiplied by the specific percentages that are outlined in IRS Publication 225. Capital gain is the remainder that's left over after you calculate the portion that's ordinary income.
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