We had a reader ask the following question:
"Can you give some advice on the impact of retiring from active farming and cash renting the farm as it relates to the 3.8% tax on capital gains. Given a large increase in the land value while actively farming, do you give up the exemption from the 3.8% Obamacare capital gains tax when you or your wife or heirs ultimately sell the farm because you used it for rental or investment income right before it was sold?"
As the reader indicates in his question, the passing of "Obamacare" back in 2010 resulted in a new net investment income tax that applies to cash rents and gains from selling farm land if your adjusted gross income is greater than $250,000. If you are actively involved in farming the land and your ground is owned by a LLC or partnership that rents the ground back to you as the farmer (either as a Schedule F sole proprietor or in an entity), this rent income is not subject to the extra 3.8% tax. The final IRS regulations issued last year indicated that this type of self-rental income is exempt from the tax.
However, once you are done farming and are simply renting the ground to other farmers (including relatives), then the rental income will be subject to the tax and even worse, selling the farmland for a large gain will result in extra tax.
For example, assume Farmer John owns 3,000 acres in a LLC with his wife. They cash rent the ground to his farm S corporation. The cash rent paid each year is $750,000. While he is actively farming, none of the $750,000 of cash rent will be subject to the tax. However, once he retires, all of the cash rent income will be subject to the new 3.8% tax (assuming enough other income to get them over the threshold amount). This results in $28,500 of extra tax each year.
If they sell the land for $30 million and have a gain of $20 million, they will owe capital gains tax of about $4 million (20%) plus another $760,000 for the net investment income tax plus any state income taxes. If they sold the farmland while actively farming, they would still owe the $4 million of capital gains tax, but not the $760,000 of NIIT.
Farmer's average age now exceeds age 58. This new tax may even increase the average in the future.