Tax Reform: Section 1031 Exchanges and the Estate Tax Implications

September 20, 2017 08:46 AM
Tax Reform

As 2017 nears its end, tax reform chatter is ramping up. Keep your eye on discussions around eliminating or curtailing Section 1031 tax-deferred exchanges and the estate tax, advises Paul Neiffer, a CPA and principal at CliftonLarsonAllen and author of the blog, “The Farm CPA.”

Section 1031 currently allows landowners and farmers to sell less productive farmland, roll that gain into new farm land and defer the tax. If the owner passes away owning the property, the deferred gain will disappear.

“Under tax reform, landowners may have to pay tax upfront and have less cash available to roll over,” Neiffer says.

For example, assume a farmer sells a quarter section for $1 million with a cost basis of $250,000. The farmer purchases new farmland for $1.5 million. Under current law, the farmer reports no gain and his basis for the new land is $750,000 ($1.5 million less the deferred gain of $750,000). Tax reform would require the farmer to pay tax on the gain of $750,000.

Estate Tax Changes

As for the estate tax, current law says when a person passes away, their heirs get a step-up in basis on most inherited assets.

For example, Henry and Martha Farmer own a farm operation. Farmland is worth $10 million with a cost basis of $1 million, plus they own farm equipment worth $2 million and have crop on hand worth another $2 million. Henry and Martha pass away in 2018. Their combined estate of $14 million is greater than the $11 million lifetime exemption amount, so the heirs will owe about $1.2 million of estate tax. However, they will inherit a new cost basis in the land of $10 million, the equipment of $2 million (depreciated over 7 years) and $2 million of grain which they can sell for $2 million and owe no taxes.

With the possible tax reform being discussed, Neiffer says, Congress would like to eliminate the estate tax. “But they are also discussing either eliminating step-up in basis or having a capital gains tax at death, similar to the Canadian tax system,” he says.

Under the new rules, the heirs of Frank and Martha will not owe any estate tax, therefore saving $1.2 million of estate tax. However, they no longer get a step-up in basis. If they liquidate all the assets in 2018, they will owe capital gains tax on the land at a rate of about 30% (combined federal and state rates) and will owe about 45% on the sale of the equipment and inventory. Total income tax will be about $4.5 million ($9 million X 30% $4 million X 45%). They saved $1.2 million of estate tax but had to pay $4.5 million of income tax for a net cost of $3.3 million.

“As you can see, eliminating estate tax can cost many farm families a lot of money if they eliminate step-up in basis or have a capital gains tax at death,” Neiffer says. “Most farmers under current laws will never owe any estate tax, but almost all farm heirs benefit from the step-up in basis.” 


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Spell Check

Lincoln, NE
9/21/2017 08:06 AM

  I have worked in Ag finance for 28 years. I do not recall even one Ag family who actually paid the federal 'Death Tax'. Yet our congressional leaders keep pitching repeal of the 'Death Tax' as one which will 'save family farms and ranches.' It should be obvious that the proposed trade-offs (loss of stepped up basis at death and loss of 1031 exchanges) would negatively affect MANY IF NOT MOST farm families at some point. It should also be obvious that repeal of the 'Death Tax' is way more important to you if you are an heir to the Walmart empire, the Koch empire or any number of the super-wealthy family empires - yet it continues to get sold to us as a benefit to 'Family businesses, and family farms and ranches'. It is time to call out your senators and congressperson for this blatant dishonesty. They know that they are lying to you - don't let them.


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