We continue to hear questions from clients regarding potential increases in capital gains in 2013, and the new 3.8 percent Medicare surtax. With many rumors floating around, we wanted to share a memo prepared by Bill Hanigan, a shareholder at the Davis Brown Law Firm, regarding how taxes could impact farmland sales in 2013.
We hope this memo helps clarify the potential impact of the Medicare surtax, and a likely increase in capital gains on your personal situation. If you are considering a sale prior to yearend, there is a small window to schedule a fall land auction and successfully close the transaction before these taxes are implemented.
New Taxes on Farmland Sales for 2013
If there is a chance that you may want to sell your farm, then you should think hard about getting it done before the end of 2012. There is a load of new taxes on capital gains and unearned income coming into effect on Jan. 1, 2013. The amount of new tax depends upon whether you were “materially participating” in farming. In any event, you must act soon to avoid some of the tax.
Coming New Years Day 2013, the new “Unearned Income Medicare Contribution” was enacted to help finance the healthcare reform act. The Supreme Court upheld the healthcare reform legislation in a 5 to 4 decision in 2012, so it is the law. Technically, it is a “surtax,” which Webster’s Dictionary calls “an extra tax or charge.” This describes the Medicare surtax, because it is a tax in addition to the tax you already pay on your capital gains, rental income, and other unearned income.
If you are materially participating in your farming operation at the time of the sale, then that is good. The new 3.8 percent Medicare surtax will not apply to your farmland sale. Furthermore, if you were actively engaged in farming for the 10 years prior to the sale, and you sold substantially all of your farming business, then you may qualify for the Iowa capital gains tax deduction.
Regardless of whether you were actively engaged or materially participating, you should expect to pay more capital gains tax in 2013. Any gain on the sale of a farm is a long-term capital gain if you have owned it for more than one year. In 2012, long-term capital gains are taxed at the 15 percent federal rate for most taxpayers. That rate will go back up to 20 percent on Jan. 1, 2013, unless Congress acts first, which is unlikely.
If you were not materially participating in your farming operation at the time of the sale, then that is bad as it relates to taxes at sale time. Beginning New Year’s Day 2013, you will add the new 3.8 percent surtax, and you won’t qualify for the Iowa capital gains tax deduction.
The Medicare surtax is complicated. For individuals, the 3.8 percent surtax applies to the lesser of “net investment income” or the excess of “modified adjusted gross income” over the “threshold amount.” Net investment income includes capital gains derived from the disposition of property – other than property held in an active trade or business – interest, dividends, rents and royalties. For single persons, the threshold amount is $200,000. Married persons filing jointly or separately have thresholds of $250,000 and $125,000, respectively.
So if you sell your long-term capital gain farmland in 2012, then your federal capital gains tax rate will be 15 percent. But if you sell it next year, then your combined capital gains rate will be 23.8 percent, subject to the thresholds. The extra 8.8 percent federal capital gains tax results from the combination of the expiration of the Bush tax cuts – thus bringing back the 20 percent capital gains rate – and the implementation of the new 3.8 percent Medicare surtax.
Let’s put some numbers to it.
Assume that a retired cash rent widowed farm landlord sells her entire farm in 2013, and reports a $1 million net capital gain from the sale of the farm. Assume that she also received $25,000 from Social Security and pension benefits. Her total adjusted gross income in 2013 will be $1,025,000. The 3.8 percent Medicare surtax applies to the lesser of the gain, or the amount by which total income exceeds the $200,000 threshold. Here, total income exceeds the threshold by $825,000 ($1,025,000 – $200,000). The Medicare surtax portion of her tax is $31,350 ($825,000 x 3.8 percent). Her capital gain tax will be $200,000 for a total federal tax on the sale of $231,350 in 2013.
Alternatively, if she sells this year, her 2012 federal tax would be $150,000 ($1 million x 15 percent). So she will pay an extra $81,350 in federal taxes for waiting until 2013 to sell the farm.
Additionally, the Iowa income tax applies to any gain on the sale of farmland located within the state. Iowa has no special capital gains tax rate. Iowa taxes capital gains at the marginal Iowa income tax rate. For 2012, the highest marginal tax rate is 8.98 percent. However, Iowa law provides for capital gains deductions for the sale of farmland sold in “the sale of a business” owned for at least 10 years, if the seller was actively engaged in the business. Generally, you have actively engaged in farming if you file IRS Schedule F. Cash rent landlords have not actively engaged in farming unless they have otherwise materially participated in any five of the previous eight years. The Iowa capital gains deduction requires “the sale of a business.” This means the sale of at least 90 percent of the business assets. Accordingly, the sale of a small part of the farm does not qualify.
If you are an active farmer and are not yet ready to give it up, then there is an alternative to the capital gains tax increase. You might sell your farm in 2012, and then lease it back for a long term from the buyer as part of the sales agreement. Title will pass to the buyer, but you stay on the farm and in your house if that is where you reside. You will avoid the additional 5 percent federal capital gains tax.
The Medicare surtax also applies to farm landlords. “Net investment income” includes farm rental income. The 3.8 percent Medicare surtax applies to that, too, subject to the threshold. In 2013, the highest combined marginal tax rate on farm rents will be 43.4 percent. This extra 8.4 percent federal tax results from the combination of the expiration of the Bush tax cuts – thus bringing back the 39.6 percent ordinary income tax rate – plus the 3.8 percent Medicare surtax.
If you want to sell the farm, it is not too late to avoid a bunch of new tax. The extra federal tax on $1 million of gain in 2013, assuming no other income, will be $80,400. If you sell during 2012, the tax savings should pay for the selling expenses, with some left over.
Bill Hanigan is a shareholder at Davis Brown Law Firm located in Des Moines, Iowa. This article is not intended to be a definitive analysis of the subjects discussed. Material contained within this article is only a general review of the particular issues and should not be considered as a substitute for advice from your attorney regarding your independent situation.