Strategies to help manage your extra 3.8 percent tax
The nightmare of the 2013 tax return preparation season was the new 3.8 percent net investment income (NII) tax. The good news is this tax only applies to the extent income on page 1 of the Form 1040 exceeds $200,000 single or $250,000 joint. Income from active farming is exempt, but farm land rental income and gains from the sale of rental land are exposed to this tax. Many farm retirees will not have rental and other income that exceeds the $200,000/$250,000 threshold. But when a land sale occurs and this tax is in play, here are some strategies to consider.
Spread the gain. Large land gains will get very expensive, with the new 20 percent top end capital gain rate plus the 3.8 percent NII tax. But a seller-financed installment sale can spread the gain over many years and stay beneath the radar of both taxes.
Defer the gain. These two tax increases will no doubt cause renewed interest in 1031 exchanges.
When sticker shock occurs on the tax cost of selling but the land needs to be moved, exchanging into replacement property may be a viable alternative.
Sell near retirement. Active business owners, whether farm or non-farm, are exempt from the 3.8 percent tax when selling real estate that’s part of their business. But a passive retiree/landlord who has rented the real estate for many years and then sells is subject to the 3.8 percent tax.
An exception applies if the sale occurs within five years of retiring from active business involvement: The seller is still considered a material participant, the real estate is an active business asset, and the gain is exempt. This exemption also applies to an installment sale contract that begins within that five-year window of ceasing active involvement.
Farm self-rentals. The regulations provide a special exemption for rental income when those who own real estate lease it to a business in which they materially participate. This requires dual ownership: You own the real estate and also own an interest in the active business in which you participate. This rule protects the 50-year-old farmer leasing his land to the farm corporation that employs him.
We can also extend this exemption into retirement years. The strategy is to have the retiree retain a small ownership interest in the active farming entity. For example, dad retires at age 68 from the family farming corporation and becomes a landlord, leasing his land to the entity being operated by the next generation. If dad keeps a small ownership percentage in the corporation, he’s now self-renting his land to a business in which he materially participates, and both the rent and any eventual land gain are exempt from the 3.8 percent tax.
Normally, material participation means achieving 500 hours of involvement each year. But there is a special override for farmers. Retiring farmers who were active until drawing Social Security are deemed to be ongoing material participants in the business, and this allows the rental income and any land sale gains to avoid the 3.8 percent tax for dad’s lifetime. — Andy Biebl, DTN Tax Columnist
[Andy Biebl is a CPA and principal with the firm of CliftonLarsonAllen LLP in Minneapolis and New Ulm, Minn., and a national authority on ag taxation. To pose questions for future columns, e-mail AskAndy@ dtn.com.]