Preparing for transition
Yes Virginia, There Is a Santa Claus, But He’s Not Called “Contract for Deed”
Selling a farm is a lot harder than it looks. There are fewer farmers who can expand their operations in times of economic uncertainty. Commodity prices have restricted cash flow and banks have tightened lending, so farmers can’t afford to purchase another farming operation in today’s environment. So what is a farmer to do?
One of the most viable options is seller financing (also known as a contract for deed or an installment sale). This is a good option when someone is considering getting out of farming, but there are some common pitfalls to consider, and these issues may make a contract for deed a less appealing strategy for selling a farm.
Most farmers know that selling equipment on a contract for deed will result in depreciation recapture in the year of sale. That is, if you depreciate equipment, you must pay back the depreciation taken in the first year of the sale. However, most people fail to understand how much tax is associated with depreciation recapture. When someone sells depreciated equipment on an installment sale, often the tax bill for the first year of the sale exceeds the first installment payment. Similar issues come up for the sale of buildings on a farm site.
Occasionally, a house or primary residence is sold with the farm. Because some or all of the gain on the sale of a house is tax-free, sellers allocate as much of the purchase price as possible to the sale of the house. If the contract for deed is not honored and the seller takes back possession of the house, the seller only has one year to resell the house in order it to avoid taxable gain. If the house is sold after the one year grace period, the gain on sale may be subject to tax (see below).
Some farmers are tempted to use contract for deeds to sell the farm to the next generation, but there is a special rule for related party sales. If a related party buyer sells the property within two years of the start of the installment sale, the original seller must recognize the amount received by the related party as an installment payment. The mechanics get a little tricky, but essentially it will generate additional tax.
Mortgage or farmland contract for deed?
Buyers and sellers can typically pick between a mortgage and farmland contract for deed. Most choose the contract for deed because it appears easier to understand. However, there are some statutory and creditor issues for both sides.
For the seller, most states require that you record the contract for deed, or face a civil penalty for failure to file within a certain timeframe. Some of my clients have executed a contract for deed but either failed to record it or recorded it late. This situation often occurs when the contract is with their child.
The buyer’s situation can be complex too, because the buyer is not deemed to own the property under the contract for deed — the seller keeps legal title until the contract is completed. Therefore, the seller may encumber the property throughout of the term of the contract. Depending on state law and whether the contract for deed was recorded, the buyer’s interest may have less priority then a lender. Simply put, if a lender forecloses on the seller while the seller retains title to the property, the bank may have the first right of repayment. As a result, the buyer may lose the property and find it difficult to get reimbursed from the seller.
The moral of this story is that both the buyer and seller must beware.
How we can help
Contract for deeds are a convenient way to sell a farm, but there are risks to both sellers and buyers. Discuss a proposed transaction with a qualified tax advisor and an attorney so that you fully understand the options and the risks associated with each scenario.