What do You Mean I Owe Tax on a Gift?

  • Agribusiness
  • 6/1/2022

Farmers who want to gift farm assets to the next generation that have debt associated with it don't always understand that tax is due. We go over the reasons why.

One of the hardest succession planning issues in transferring property from the current generation to the next generation is gifting property with debt.

Generally a gift of property does not create any income tax. The income tax cost basis of the property will carry over to the person receiving the gift. However, if the transfer of property has no cost basis and their is debt that is transferred with property then income tax will be due. Let’s look at an example:

John gifts a 2019 tractor to his daughter Ann. The original cost was $300,000 and it has been fully depreciated and there is still $100,000 of debt outstanding on the tractor that Ann assumes. In this case, John was owe tax on $100,000 of gain. He essentially sold the tractor to Ann for the amount of debt he no longer owes.

We can mitigate this by having John continue to owe the debt, however, this means he has to pay the debt and may need to create income to fund the debt payments. All he has done is push the tax down the road in that situation.

Many farm operations farm as a partnership and in many cases there is little or no tax cost basis in the assets. Grain inventories, prepaid farm inputs, accounts receivable, cost of growing crop and most farm equipment have no cost basis. However, most farm partnerships have debt and in some cases, this debt can be substantial.

This creates a “negative capital account” for each partner and if one partner wants to gift their capital account to the next generation then income tax is due on the negative amount.

How do we get rid of this. The most effective way to get rid of this negative capital amount is not friendly to the farmer. They have to die. When the farmer passes away, we are able to step-up the basis in all of the farm assets and this eliminates the negative capital account and then we can gift it to the next generation.

However, this leads to complications and delays in getting those assets timely passed down to the next generation. It would be much better if farmers continue to calculate what this amount is each year and determine a plan to eliminate or sharply reduce this negative capital account.

It will entail some pain but it is likely better than waiting to pass away to eliminate the tax.

Also, when a farmer wants to sell their interest in a farm partnership with negative capital, friction can arise among the partners. For example, I had reviewed a farm partnership a few years back with about $40 million of farm assets and about $30 million of debt. There were four equal brothers that owned the partnership. One brother wanted bought out. He thought his value was $2.5 million. However, if the partnership was liquidated and paid tax on the $40 million of assets, the net value of the partnership might actually be a negative $10 million. The brothers could not agree. Now, a Section 754 election would step-up the purchase by the three brothers and mitigate a future tax on this share of the assets, but there was still disagreement among the four brothers. It is always messy.

The bottom line is debt on farm assets makes it hard to gift those assets to the next generation. It takes careful planning to minimize the impact and there is usually some “tax pain” associated with getting rid of it.

This blog contains general information and does not constitute the rendering of legal, accounting, investment, tax, or other professional services. Consult with your advisors regarding the applicability of this content to your specific circumstances.

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