The Sale of Farmland (or Other Business Assets) Placed in Trusts
Many farm families have seen a rapid appreciation in their land values over the last decade, and much of this land is being passed from one generation to the next. People inheriting the land naturally assume they will receive a step-up in basis to fair market value, which would allow them to sell the land for little or no gain. However, many properties have been placed in trust for the benefit of the surviving spouse or other relatives, and in these cases, the cost basis of the land may be decades old and the resulting gain on sale is a surprise to the heirs.
For example, assume Grandpa owned 500 acres of land and passed away in 1970 when the land was worth $50,000. This property was placed in a trust for Grandma’s benefit until her death in 2013 when the land was worth $5 million. Under the terms of the trust, the land is then distributed to the grandchildren, and they sell it for $5 million. Even though it was worth $5 million when Grandma died, the grandchildren have to use the $50,000 cost basis since this land was not included in Grandma’s estate.
A complicated calculation
To determine the amount of gain subject to income tax, the heir would subtract the cost of selling the farmland (e.g., commissions, escrow, title, excise taxes) from the sales price, and then subtract the net cost basis of the land. This resulting gain is then subject to federal and state tax as follows:
- There will be a zero percent tax on the amount of gain that is in the 10 – 15 percent tax bracket. For 2013, this tax bracket cuts-off at about $72,000 of taxable income (for married couples). A couple would calculate all of their other ordinary income after deductions, and if this amount is less than $72,000, then the difference would be the amount of capital gains that could be taxed at zero.
For example, assume a couple has ordinary income after all deductions of $30,000. They have a $200,000 gain from selling farmland. The tax bracket cut-off is $72,000, and they subtract their ordinary income of $30,000. So the gain of $42,000 would be taxed at zero percent, and the remainder would be taxed at 15 percent.
- For couples whose adjusted gross income is greater than $250,000 and taxable income is less than $450,000, the long-term capital gain will be subject to at least an 18.8 percent tax rate due to the net investment income surtax (NIIT) of 3.8 percent.
- For those couples whose taxable income exceeds $450,000, their effective long-term capital gains rate will be at least 23.8 percent since they are now in the maximum capital gains rate of 20 percent plus the NIIT of 3.8 percent.
- Phase-outs of itemized deductions and exemptions add a few more percentage points to the effective rate as adjusted gross income exceeds $300,000 for a married couple.
The state capital gains tax paid is usually deductible on the federal return. However, if the taxpayer is subject to the Alternative Minimum Tax (AMT), the state tax deduction may have little or no value to the taxpayer.
Each trust is unique
The tax basis of property distributions from trusts depends upon the specific provisions of the trust and whether trust assets were includable in the taxable estate. The above example illustrates the common misunderstanding of the basis “step-up” rules. Even experienced tax professionals can only offer counsel after they have had the opportunity to review the trust document, understand how the trust was formed, and determine whether certain elections were made by an earlier estate.