Allocating the sale price of a farm or ranch among the different types of assets involved in a sale is a necessary and often neglected task.
Internal Revenue Code (IRC) Section 1001(a): states that a taxpayer realizes gain or loss on the “sale or other disposition of property”—it generally defines gain and losses to consist of the difference between the amount realized on the “sale or disposition” of an asset and the adjusted basis of an asset. The basis of an asset is typically determined under IRC Section 1012 (purchase: cost), 1014 (inherited: date-of-death fair market value), or 1015 (gift: carry-over basis from donor).
The sale of a ranch will typically involve the realization of gain upon the sale of a “mixed bag” of assets. Some gain will need to be recognized as capital gain or ordinary income in the year of sale, while some realized gain might not need to be recognized due to the operation of IRC Sections 121, 664 or 1031.
This “mixed bag” of assets often includes a personal residence, fixtures (outbuildings, barns, fences, wells, etc.), personal property (equipment, sprinkling systems, livestock, etc.), and land. IRC Section 1060 requires that “the consideration received for such assets shall be allocated among such assets.”
Of particular significance is the following requirement: “… the transferee and transferor (shall) agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, (and) such agreement shall be binding on both the transferee and transferor unless the secretary determines that such allocation (or fair market value) is not appropriate.”
Inasmuch as most realtors are not also tax professionals, it is not uncommon for this important requirement to be ignored in the context of drafting and executing a buy-sell agreement and associated documents.
This creates a problem for both parties in the context of preparation of tax returns, as IRS regulations require that both the seller and purchaser of a group of assets that makes up a trade or business must use Form 8594 to report such a sale if the purchaser’s tax basis (IRC Section 1012) in the assets is determined by the amount paid for the assets. And, each party must attach Form 8594, reflecting agreed-upon allocated values, to his income tax return for the tax year in which the sale date occurred.
The IRS instructions to Form 8594 specifically state as follows:
Generally, both the purchaser and seller must file Form 8594 and attach it to their income tax returns when there is a transfer of a group of assets that make up a trade or business (defined below) and the purchaser’s basis in such assets is determined wholly by the amount paid for the assets. This applies whether the group of assets constitutes a trade or business in the hands of the seller, the purchaser, or both.
However, you are not required to file Form 8594 if the following applies: A group of assets that makes up a trade or business is exchanged for like-kind property in a transaction to which Section 1031 or 664 applies. If Section 1031 or 664 do not apply to all the assets transferred, however, Form 8594 is required for the part of the group of assets to which Section 1031 or 664 do not apply.
In the context of preparing Form 8594, an allocation of the purchase price must be made to determine the purchaser’s basis in each acquired asset and the seller’s gain or loss on the transfer of each asset. Often, unless there is a definite reflection of value, such as a current appraisal, the values to be allocated to various assets is left to the negotiation and determination, in writing, of the parties and their legal representatives. For example, a seller will generally want high valuations applied to a personal residence (non-recognition of gain up to $500,000 in the event of a married couple) and land (taxation at capital gain rates). Conversely, a buyer will want higher valuations applied to depreciable personal property and fixtures.
While county property tax valuations may be helpful in this regard, they often do not reflect current fair market values. When necessary, a qualified farm/ranch real estate agent or an appraiser is often engaged to assist in arriving at “correct” values.
The values agreed-upon in writing by the parties are typically acceptable to IRS, unless so skewered as to not be representative of actual values (e.g., such might occur in the case of a corporate seller with a large net operating loss deduction who agrees to an allocation of an inordinately high value to depreciable assets.)
The seller will typically wish to see an asset value allocation as follows:
First, personal residence. For a married couple, up to $500,000 of gain realized upon the sale of a personal residence does not need to be recognized (reported on your tax return).
Next, raw land, which is generally taxed at favorable long-term capital gain tax rates.
Then, fixtures (buildings, barns, etc.) In most cases, IRC Section 1250 does not mandate depreciation recapture on these types of assets, except to the extent there has been “additional depreciation” (depreciation allowances in excess of straight-line depreciation). Note, all such buildings placed in service after 1986 must have been depreciated using the straight-line method;
Next, personal property such as equipment, tractors, or breeding livestock. These types of depreciable assets are typically subject to IRC Section 1245 recapture. In such case, the amount of gain (based upon the allocated purchase price) treated as ordinary income is the lesser of the total gain realized on the disposition of the assets, or the depreciation deduction previously taken with respect to the asset.
The IRC Section 1031 Exchange and IRC Section 664 Charitable Remainder Trust are powerful tax deferral strategies that can be used when selling farm and ranch property. Even in the context of a complete or partial sale involving a 1031 exchange or charitable remainder trust, ordinary income recognition on the recapture of deprecation may occur. Thus, it is important, even in this context, to negotiate the most tax-favorable allocation of asset value. — Chris Nolt, owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC
