By Marc Lovell, University of Illinois
Selling a farm with unharvested crops presents some unique tax issues. The tax rules today may provide the farmer with far greater advantages than the rules that existed back in 1953 when the Supreme Court first ruled on the tax treatment of the sale of farmland with standing crops, but care must be taken to assess the impact of the tax rules and structure the sale transaction to minimize the tax costs of the sale.
Early Supreme Court Ruling
A Supreme Court case involved Mrs. Gladys Watson, who had sold her interest in a 110-acre orange grove located in California. At the time of the sale, the tax rules seemed rather clear to Mrs. Watson who treated her profit on the sale of the orange grove as a capital gain. The IRS, however, took exception to Mrs. Watson's capital gain treatment of the sale because when the property was sold, there were unharvested oranges growing on the property. If Mrs. Watson had waited until the orange harvest and sold the oranges, the proceeds from the sales of that crop would have been taxed as ordinary income, not as a capital gain.
The IRS argued to the Court that part of the property's purchase price paid to Mrs. Watson was for the land and part of that price was for the orange crop. The land sale, the IRS contended, was rightfully treated as a capital gain by Mrs. Watson but that part of the purchase price attributable to the unharvested oranges should be taxed as ordinary income. The Supreme Court agreed with the IRS, noting that under the relevant section of the tax code in effect at that time, capital gain treatment was to be given to property "used in the trade or business..." and not given to property "held by the taxpayer primarily for sale to customers in the ordinary course of [the] trade or business."
Today's farmer selling land with unharvested crops will find the tax rules far more favorable and flexible than those that applied to Mrs. Watson's orange grove sale.
The "Double Advantage" of Today's Tax Code §1231 for Farm Sales
First, IRC §1231 of our current tax code provides the farmer with some distinct advantages upon the sale or exchange of "property used in a trade or business" that the farmer holds for more than 1 year. Generally, the farmer's gain from the sale of "section 1231 property" will be treated as a long term capital gain (which means a favorable tax rate for the farmer on that gain). In addition, the farmer's loss on the sale of this type of property is treated as an ordinary loss (meaning that the farmer can apply the loss amount against other sources of income for the year). If the loss were characterized as a capital loss instead, the farmer would be limited to applying that loss only against capital gains plus an annual limit of $3,000 that could be claimed against other income.
Section 1231 has some limitations and other tax code sections can cause the farmer to pay additional taxes, particularly if the farmer claimed depreciation on the property sold or exchanged. However, §1231 generally provides the farmer with a "double advantage": favorable capital gains tax treatment on gains and favorable ordinary loss treatment on losses.
Second, this §1231 double advantage specifically applies to unharvested crops that are growing on farmland that is sold or exchanged if certain conditions are met. Unlike Mrs. Watson, today's farmer might benefit from §1231 advantaged tax treatment on the unharvested crops if:
- The unharvested crops are on farmland held for more than 1 year and used in the farmer's trade or business of farming, and
- The farmland and the unharvested crops are both sold at the same time and to the same person.
However, this advantageous tax treatment will not apply if the farmer retains any right or option to reacquire the farmland in the sale or exchange transaction. However, if the farmer retains the customary rights associated with providing the buyer with a mortgage upon selling the property, retaining these rights will not "taint" the favorable tax treatment given to the unharvested crops on the farmland sold.
If the farmer is transferring an interest in farmland that falls short of an ownership interest, such as the transfer of a lease on the farmland, crops growing on that farmland do not qualify for favorable capital gains tax treatment.
Depending on the farmer's tax circumstances, however, the farmer may find that the application of §1231 to unharvested crops may not be advantageous.
Costs of Production for Qualifying Unharvested Crops
Production costs associated with unharvested crops that benefit from the favorable capital gains tax treatment rule are not deductible. These production costs are instead added to the basis of the unharvested crop that is part of the farmland sale. This serves to reduce the amount of taxable long term capital gain from the sale of the property instead of reducing ordinary income for the farmer in the tax year in which the property is sold. Production costs attributable to the unharvested crops include items such as: