I have gotten several questions on equipment 1031 exchanges. Under both the House and the Senate Proposals, 1031 exchanges would only be allowed for real property. Many farmers are concerned that if they exchange their equipment, that this will no longer be tax-free. The answer is yes, it is not tax-free, but it might not matter.
In order to have a 1031 equipment exchange, you must have both a sale and then a purchase of equipment of equal or greater value to be a valid tax-deferred exchange. The House Bill would allow you to deduct 100% of your equipment purchases for the next five years and after that point, Section 179 would increase to $5 million which would cover most farm equipment purchases. The Senate is not quite as nice. They bump Section 179 to $1 million starting next year, but only allow 100% bonus depreciation on new equipment, not used equipment.
Let's look at some examples.
Farmer Smith exchanges a tractor worth $100,000 (fully depreciated) for a new tractor that costs $300,000. His cash out-of-pocket is $200,000. Under current law, there is no gain on the exchange of the old tractor and Farmer Smith gets to take Section 179 on the $200,000 of cash paid (or take bonus and depreciate the rest). Under the House Bill, he would recognize $100,000 of income on the exchange (but not subject to self-employment tax) and then be allowed to fully depreciate the $300,000 cost of the new tractor (reducing SE income). This is actually better for all sole proprietor farmers than current law. The Senate would allow the same thing for new equipment for the next five years. If it is used equipment, you then have to take Section 179 to write off the new piece of equipment in full.
Generally, this is the treatment; however, there is at least one situation where this is not as generous. Suppose Farmer Smith exchanges his tractor using a tax-deferred exchange and sells his tractor for $100,000 on December 29 and then buys a new tractor for $300,000. In this situation, he recognizes gain in year 1, but can't deduct until the next year.
Deemed Rate of Return and Interest Expense
The House Bill does have the provision that allows a farmer to treat 30% of his farm income subject to the maximum 25% tax rate or they can apply the deemed rate of return calculation if that would lower their tax bill. However, this calculation requires you to reduce the amount allowed by any interest expense paid and locks you into this calculation for five years. Let's look at a couple of examples:
Farmer Jones has adjusted basis in his farm equipment of $1 million. The deemed rate of return is 7% plus the S/T AFR rate of let's assume 1% for a total deemed rate of return of 8%. Therefore, up to $80,000 of farm income may be subject to the lower 25% tax rate. Now, if he has leveraged this equipment and pays $40,000 of interest, this would drop the amount he can have taxed at the 25% rate to only $40,000. If he earned $200,000, under the 70/30 rule, he could have $60,000 taxed at 25% which is $20,000 more than the deemed rate of return calculation.
Now, let's assume the farm equipment was fully depreciated and he did not owe any debt on the equipment. Under this situation, none of the income is allowed for the 25% top rate. Since you are locked in for five years using this method and interest expense deducted will reduce the income subject to the lower rate, care must be taken in deciding which is best.
Now, none of this may happen, but we just want to keep you posted on what might happen.