Tax Q&A: Depreciation, land rent and Social Security, owner-employee taxes

Mar 7, 2014
by WLJ

Q. Because it appears Section 179 will be much lower this year than in the past, I was wondering if the IRS would allow a depreciated tractor to be traded in on a new machine shed without claiming any value for the depreciated tractor.

A. Section 1031 of the tax code does allow tax-deferred exchanges, but there is a “like-kind” requirement. Most real estate is generically considered like-kind, and farm machinery generally is all in the same likekind category. But machinery is not like-kind with respect to real estate. So unfortunately, your strategy is not workable.

The disposition of the tractor would be treated as a sale at its market value. You would be considered to invest that same amount in the new machine shed. And assuming that 50 percent bonus depreciation on new assets is not renewed, the tax cost of the new machine shed would be spread over a long 20-year recovery period. Bottom line: You would have the same tax result on this exchange as if you had sold the tractor and used the funds to pay for the machine shed.

Q. Does it matter how much cash rent you pay to a landlord if that person is drawing Social Security? Is there a cutoff to keep them from a higher tax bracket? I am considering an arrangement to pay cash rent to my mother, but want her to be able to retain her Social Security with no problems.

A. There are two separate mechanisms under which current-year income can affect Social Security benefits. The first is very narrow and only relates to those drawing Social Security benefits between ages 62 and today’s full retirement age of 66. These folks who draw early before full retirement age are restricted in the amount of earned income (wages and selfemployment income) they can receive without forfeiting back to Social Security some of their benefits. This would not apply in your mother’s case, because even if she is drawing Social Security benefits early, cash rent is not earned income and would not cause the forfeiture of benefits.

The second rule applies to any Social Security recipient. It does not cause payback of benefits, but rather causes a portion of the benefits to be reportable as taxable income. The amount of benefits included in your mom’s 1040 will depend on her overall tax return income. This formula looks to page 1 adjusted gross income, with a few very narrow modifications, plus 50 percent of her Social Security benefits plus tax-exempt interest income. If the sum of these exceeds $25,000, a complex formula begins including a portion of the Social Security in 1040 income. The greater the overall income, the greater the portion of Social Security benefits that are taxable. The formula ends when 85 percent of the Social Security benefits become taxable.

The only way to accurately assess the impact of additional cash rent in mom’s tax return is to have her tax preparer do a “what if” tax projection, comparing where she is today versus where she would be with added rent income. That will quickly identify the tax increase that will occur. If Mom’s income is very low, there may be no inclusion of Social Security benefits if her income increases slightly. Similarly, if her income is already very high, she may already be at 85 percent reportable Social Security benefits, so the added rental income does not affect the formula. It is those taxpayers in the middle, roughly in the $20,000- $50,000 income range, that are most severely affected by this nasty little formula.

Q. I recently read your article regarding the new rental income tax. You stated that active business owners are not exposed to the 3.8 percent net investment income tax. My husband and I own farmland and lease it to our C corporation, which we also own.

We are the only employees of that corporation. How do we file for this exemption and what requirements must be met? Are there any self-employment tax consequences if we are materially participating as landlords?

A. I am assuming you cash rent, or perhaps cropshare rent, your land to your C corporation and do not actually participate in the farming activity as landlords (although you do participate as an employee of the corporation in its farming activities). As a passive landlord who selfrents land to a material participation C corporation, you are exempt from the 3.8 percent net investment income tax [Reg. 1.1411-4(g) (6)].

In terms of disclosure in your tax return, you would report the rental income on line 4a of IRS Form 8960 (the form that computes the 3.8 percent net investment income tax). But on line 4b, you would subtract that rental income because of its self-rental status exempting it from the 3.8 percent tax.

If you were a landlord who materially participated as a crop-share lessor in the farming arrangement, you would be subject to selfemployed Social Security tax on the land rent. That would technically exempt you from the 3.8 percent tax, but you have stepped into a costlier 15.3 percent self-employed Social Security tax, or at a minimum an equivalent 3.8 percent Medicare tax if your selfemployment income exceeded the Social Security earnings base of $117,000 (2014 amount). Normally there is little reason to be a materially participating landlord in your lease arrangement to your C corporation. You should define your arrangement to be that of a cash-rent lessor, or alternatively, a non-participating crop-share lessor. — Andy Biebl, DTN Tax Columnist