By Corey Clark and Chris Bardenhagen
Farmers often want to pass their farmland on to their successors. Some individuals choose to sell the land, some choose to gift the land and others choose to pass the land on as an inheritance. All of these choices have income tax consequences.
When real estate property is sold, a “taxable event” occurs. Many sales of farmland result in capital gains, which occur when the sale price exceeds the tax basis. Capital gains are taxable income. In the simplest cases, the basis of the land is the original purchase price. Property improvements, such as tile, would change the basis of the land. Check with your accountant to determine the actual tax basis of your land. Long term capital gains rates (up to 20%) apply if the property was held for more than one year. For more information, see Topic #409 at the IRS website.
Case example
To better understand stepped-up basis, let’s evaluate the case of Jonathon, who purchased an 80-acre parcel of land for $200,000 in 1980. Jonathon has been farming the land since 1980, and the current basis remains $200,000. Jonathon has a daughter, Anna, to whom he wants to transfer the land. He has three options: sell the land to Anna, gift the land to Anna or pass the land to Anna at his death. Each of these options has significant tax implications.
Cash sale. If Jonathon sells the parcel to Anna in 2024 for the full market value of $1,000,000, Jonathan will have a long-term capital gain of $800,000. This is because the sale price exceeds his $200,000 basis by $800,000 and the property was held for more than one year. The gain of $800,000 is taxable at long term capital gains rates. In this case, Jonathon would owe the IRS approximately 20% x $800,000 or $160,000 of tax related to the sale of the parcel. Anna’s basis in the land would be $1,000,000.
Gifting. When property is gifted, the basis of the person giving the land (the “giftor”) is passed along to the receiver. If Jonathon gifts the property to Anna, then her basis will remain $200,000, which is what Jonathon paid for it in 1980.
Inheritance. Current tax rules allow property transferred through inheritance to receive a stepped-up basis. The basis is stepped up to the current market value of that asset at the death of the giftor. Consider the scenario in which Jonathon dies in 2024 and passes the property to Anna through a will or trust. Since the market value of the land at that time is $1,000,000. Anna’s basis will be $1,000,000 instead of the $200,000 basis that Jonathon had before his death. For more information on stepped-up basis, view U.S. Code Title 26, §1014(a).
Sales implications
So, what is the taxable effect of these different transfers and basis? In our scenario, Anna chooses to sell the land in 2026 for $1,200,000. We will assume for this example that tax laws remain the same.
If Anna had purchased the land from Jonathon in 2024, she would have a long-term capital gain of $200,000 in 2026 ($1,200,000 sale - $1,000,000 basis). Anna would benefit $200,000 from the sale ($1,200,000 sale - $1,000,000 purchase price), but she must pay tax on the capital gain. At long-term capital gains rates of 20%, her tax liability would be $40,000 ($200,000 x 20%). Anna’s net benefit, the amount that she would take home after the purchase price and taxes, would be her $200,000 gain minus $40,000 tax = $160,000.
If Jonathan had gifted the land to Anna in 2024, she would have a long-term capital gain of $1,000,000 after the sale in 2026 ($1,200,000 sale minus the $200,000 basis she inherited from Jonathon). Anna would benefit from the entire $1,200,000 since she did not pay for the land, but she still must pay tax on the capital gain. At long-term capital gains rates of 20%, her tax liability would be $200,000 ($1,000,000 gain x 20% tax). Anna’s net benefit would be $1,200,000 full sale price minus $200,000 tax = $1,000,000.
If Anna inherited the land after Jonathan’s passing, the land would have had a step up in basis to $1,000,000 at his death in 2024. Anna would have a long-term capital gain of $200,000 from selling the land in 2026 ($1,200,000 sale price - $1,000,000 basis), and she would benefit from the entire $1,200,000. She still must pay tax on the gain, which at long-term capital gains rates of 20% would be $40,000 ($200,000 gain x 20%). Her net benefit would be $1,200,000 full sale price - $40,000 tax = $1,160,000.
In summary, farmland owners have multiple choices for transferring their land, each of which determines the tax basis of the new owner. The basis of the property steps up if transferred through a will or trust. In the case above, Anna was able to keep an extra $160,000 from the sale when she received the property through inheritance. However, it is important to note that if it was gifted to Anna during Jonathon’s life, and she sold it in 2026, she would still have a net benefit of $1,000,000 after the sale.
There are situations where it can be preferable to transfer the property before the death of the landowner. Common examples are when there are estate tax implications or when the recipient plans to farm the land and not sell it. The purpose of these scenarios is to help you understand the value of stepped-up basis and the tax trade-offs of transferring land sooner rather than later. The most important trade-off is the taxes that will have to be paid if the parcel does end up being sold by the land recipient.
Keep in mind that tax laws are often reviewed and changed by Congress. There is no guarantee that a stepped-up basis will apply in the future. Check with your accountant for the latest information on tax laws and how they impact your options for transferring farmland.
Source : msu.edu