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How the new tax law affects farm equipment trades

Contributed by Paul Neiffer Published on 06 March 2018

Tax codes on equipment trades just got trickier.

Under old tax law, a farmer could trade in farm equipment and recognize no gain or loss on the trade. For example, assume a farmer has an old combine worth $200,000 and trades it in for a new combine worth $500,000. The $200,000 trade value is essentially ignored and the tax cost basis of the new combine is simply $300,000 (the net cash paid).

However, the new tax law does not allow tax-free trades on farm equipment. In our example, the farmer will recognize a sale on the old combine of $200,000 (likely all gain), and then on the new combine, the tax cost basis will now be $500,000, which is allowed to be deducted 100 percent until Dec. 31, 2022. After that date, bonus depreciation drops by 20 percent each year; therefore, beginning in 2027, the farmer will have to report 100 percent of the gain on the trade and may only be able to deduct the new combine using either Section 179 (of $1 million) or regular depreciation.

For farmers in a state without state income taxes, this new provision can save some taxes (at least until 2023). The gain on the trade is not subject to self-employment taxes, and the deduction on the new combine reduces self-employment taxes.

However, many states have restrictions on the amount of Section 179 or bonus depreciation that can be taken. Many of the key farm states limit Section 179 to $25,000 or have an add-back of some percentage of the excess over $25,000. Here is a list of those states:

  • Arkansas
  • California
  • Hawaii
  • Indiana
  • Maryland
  • Minnesota (add back 80 percent of Section 179 in excess of $25,000)
  • New Jersey
  • Ohio (have to add back certain percentages in excess of $25,000)
  • Pennsylvania

Almost all of the key ag states do not allow bonus depreciation. The ones that allow bonus depreciation the same as federal are as follows:

  • Alabama
  • Arizona
  • Colorado
  • Kansas
  • Louisiana
  • Michigan
  • Missouri
  • Montana
  • Nebraska
  • New Mexico
  • North Dakota
  • Oklahoma
  • Oregon
  • Utah
  • West Virginia

The general assumption is that for those states with no bonus depreciation and limited Section 179, the elimination of the trade-in provisions will always result in extra tax. However, in many situations, the “sale” will actually now result in a tax loss in those states. Although the farmer may recognize a loss on the sale, the farmer will have lower depreciation on the new asset, so likely the bottom line is an overall increase in state taxable income versus federal taxable income for the year of trade.

Let’s look at an example:

Assume the farmer purchased the combine in 2015 for $400,000 and depreciated it over seven years. The deduction for 2015-17 is $119,387.75. The combine is traded in 2018, so the depreciation deduction for the current year is $30,065.60, resulting in accumulated deprecation of $149,453.35. The combine now has an adjusted tax cost basis of $250,546.65 and the selling price is now $200,000, resulting in a state tax loss of $50,546.65. On the new combine, the farmer can only deduct $100,000 (assuming the state conforms to the new five-year 200 declining balance method for farm equipment). Therefore, under federal rules, the farmer reported a gain of $200,000 and a deduction of $500,000 for a net deduction of $300,000. In the state, the farmer reported a loss on the sale of $50,546.65 and deducted $100,000 for a net deduction of $150,546.65. The farmer gained a net deduction of about $150,000 on the federal return. However, the farmer will continue to write off $400,000 against his or her net state income over the next five years.

Now, some states such as Minnesota and Ohio have interesting adjustments, and in certain situations, the farmer may lose the benefit of this deduction, but for most other states, this is how it would work.

The bottom line is that state taxable income will still likely be much higher for farmers who trade in farm equipment than federal taxable income.

So, as discussed, trading in farm equipment has become much more complicated. Under the old law, the tax code required you to defer and roll over the trade gain into the new equipment and reduce the value by this amount. The cost basis of the asset traded in (if any) was added to the cash or boot paid for the new piece of farm equipment. You could not take Section 179 on the old asset’s basis, but you could take 50 percent bonus depreciation on it.

Here is an example of the old law:

Farmer Jones has a combine worth $200,000 that still has a cost basis of $100,000. He trades it in on a new combine worth $500,000. His tax cost basis in the new combine is now $400,000 ($300,000 cash paid plus $100,000 cost basis from the old combine). He can only take Section 179 of up to $300,000 on the new combine but can take 50 percent bonus depreciation on all $400,000 if no Section 179 was taken. Any remaining basis is then depreciated over seven years.

Now the new law changes this. The farmer is now required to report the trade-in value as the sale price. This will usually result in a gain on sale for federal income tax purposes since most farm equipment has been fully depreciated over the last few years using Section 179 or bonus depreciation. However, the cost basis of the new equipment is now the full price.

In our example above, the farmer would recognize a gain of $100,000 ($200,000-$100,000 cost basis) on the traded-in combine. He then fully depreciates the new combine and writes off $500,000 in the current year.

However, here is where it can get more complicated. Since net operating losses can only offset 80 percent of taxable income starting in 2018, the farmer may want to elect out of 100 percent bonus depreciation on the combine and only use enough Section 179 to get his taxable income down to the correct number.

Again, using our example. Assume Farmer Jones wants to report $200,000 of taxable income. If he fully depreciates the combine, his income is zero. Therefore, he can elect out of bonus depreciation and use Section 179 to get his income down to $200,000 and have $300,000 or so of basis that he can depreciate over the next five to seven years – five if new and seven if the combine is used.

One other problem area that really may start to show its head is Section 1245 recapture on the sale. Many farmers have done equipment exchanges year-after-year, and in many cases, the total cost of the new combine never shows up on the depreciation schedule, which may cause some of the gain on the trade-in to be treated as Section 1231 gain when in reality it is actually Section 1245 ordinary income recapture. Since all trades will now have to be reported as a sale, this will likely happen.

As an example, assume a combine was purchased in 2017 for $500,000 but had a trade that reduced the tax “cost” basis to $100,000. The farmer then took Section 179 of $100,000 and brought the tax basis down to zero. The combine is then traded in for a new combine in 2018 with a value of $400,000. If the combine is only shown on the depreciation schedule as “original” cost of $100,000, many tax preparers would show an ordinary gain of $100,000 and Section 1231 capital gain of $300,000. The correct number is $400,000 of Section 1245 since the combine trade value was less than its original cost of $500,000. You can only have Section 1231 gains on the excess of actual original cost of equipment or asset purchased.

As you can see, trades will be tougher to deal with starting this year.  end mark

Paul Neiffer is a certified public accountant and business advisor. He is also a principal with CliftonLarsonAllen in Yakima, Washington. Email Paul Neiffer.

This originally appeared on CliftonLarsonAllen's blog.

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