Due to much of the western US being on fire, we have received more than a few inquiries about tax treatment of involuntary conversion of livestock.
If a farmer sells livestock because of consequences of a drought, the payment of income tax on the taxable gain from the sale may be postponed. There are two tax treatments, both of which apply only to drought related sales of livestock in excess of normal livestock sales. Other weather related issues such as hurricanes, flooding, etc. do not qualify for these treatments, however, fires caused by drought conditions or lack of grass for grazing due to drought conditions would qualify.
If livestock (other than poultry) held for draft, breeding, or dairy (no sporting) purposes are sold because of drought conditions, the gain realized on the sale does not have to be recognized if the proceeds are used to purchase replacement livestock within two years of the end of the tax year of the drought sale. Also, the new livestock must be used for the same purposes. For example, if a farmer normally culls 30 cows from a herd each year, but in a year of a drought 50 cows are culled, the gain on sale of the additional 20 cows is deferred assuming replacement animals are purchased within the appropriate replacement period. The replacement period is either two or four years. Two years normally and four years if the area has been designated as eligible for assistance from the federal government due to weather related issues. To make this election, a statement is attached to the tax return that includes the following:
- Evidence of existence of the drought conditions that forced the sale or exchange of the livestock.
- A computation of the amount of gain realized on the sale or exchange.
- The number and kind of livestock sold or exchanged.
- The number of livestock of each kind that would have been sold or exchanged under the usual business practice if the drought had not occurred.
Defer Income to the Subsequent Year
This option applies to all livestock sold due to drought conditions. To qualify, the taxpayer must show that the livestock would normally have been sold in a subsequent year. Furthermore, a drought that caused an area to be declared a disaster area must have caused the sale of livestock. It is not necessary that the livestock be raised or sold in the declared disaster area. The sale can take place before or after an area is declared a disaster area as long as the same disaster caused the sale. Same as above, the amount deferred is the additional amount received for livestock sold due to the drought conditions. Using the same facts as the above example, the 20 additional cows sold in year 1 would be reported in year 2.
The election for this option must be made by the due date of the return (including extensions) for the tax year in which the drought sale occurred. The election is made by attaching a statement to the return that includes the following information:
- A declaration that the taxpayer is making an election under IRS Code Section 451(e).
- Evidence of the existence of the drought conditions that forced the taxpayer’s early sale or exchange of the livestock.
- The total number of animals sold in each of the three preceding years.
- The number of animals that would have been sold in the taxable year had the taxpayer followed his or her normal business practice in the absence of drought.
- The total number of animals sold and the number sold because of drought during the taxable year.
- A computation, pursuant to Reg. IRS Code Section 1.451-7(e) (the computation shown above), of the amount of income to be deferred for each such classification.
The biggest difference in the option is all livestock are eligible and there is no need for replacing the livestock.
If you have sold more livestock than normal due to drought related issues, talk with your tax advisor about which opportunity is best for you. There are subtle but important differences with each option and the above only scratches the surface of considerations to take into account.