Admittedly my friend Zach probably isn't paying full market value for his uncle's share of an irrigated specialty farm, but the size and responsibility of his multi-million dollar, 30-year note still keeps the young farmer up nights. Returns from the produce industry can swing wildly, based on weather damage, port strikes, the dollar's exchange rate, even migrant labor hassles. Farm lenders like to say Iowa corn growers can lose $100/acre, but it's easy to lose $1,000/acre some years in potatoes. Don't ask about apples, cherries, grapes and wine.
Conventional farm mortgages don't offer much payment flexibility, but Zach (not his real name) built in four "escape clauses" to skip some of his annual payments of principal should the farm suffer a rough year. Especially because it's family financing, he reserves that option for extreme cases only and says he would never want to elect that option two years in a row.
Fortunately for both the farm successor and the retiring generation, an installment payment plan eases some of Zach's anxiety--as well as tax consequences for his uncle. Not only can a young farmer lock in an attractive interest rate with an owner financed installment sale, but his uncle avoids a massive tax bill on his capital gains and knows that his heirs (Zach's cousins) will get a steady return in the long run. (For transactions in August 2015, IRS set the minimum Applicable Federal Rate for 9-years or longer debt at 2.82%, although a retiring farmer may want something higher like 4% to 5%, financial advisers say. )
"It's really a way to make a land sale affordable for a young farmer," said Chris Hesse, a Minneapolis-based CPA with CliftonLarsonAllen. "For a retiree leery of stocks or bonds, the note is an alternative investment with potentially less volatility."
Death does not erase a debt. Normallythe liability is assumed by the person who succeeds to the asset upon death. But some families add a self-cancelling installment note (SCIN)whichforgives the debt at the seller's dealth. The buyer of the property pays a premium for the feature. That could be an enhanced interest rate or an additional purchase price, Hesse said.
Except for family sales, seller financing virtually vanished after the farm crisis of the 1980s when farmland values burst and many buyers walked away from their contracts, returning title to the original owners. Now even arm's length installment sales should become more popular due to recent tax law changes and the current interest rate environment, Hesse and other CPAs say.
"If sellers are concerned about a steep fall in land values, I'd advise them to ask for a 30% or so down payment, enough so the buyer has skin in the game," Hesse added.
But benefits from tax savings really drive the practice. Between 2003 and 2012, the federal tax on capital gains topped out at 15%. Since Congress hiked rates effective January 1, 2013, four tiers of rates affect capital gains now. And the effective rates may be much higher than the maximum 23.8% advertised, thanks to our complex tax system.
"If you have a land sale in your future, the best money you can spend is to have a tax professional run the software to help calculate your tax bill before you list," Hesse says. "We see a lot of landowners with sticker shock once we run the numbers." So good tax advisers can more than justify their fees.
Under our current tax system, capital gain taxation falls into a three-tiered rate system: 0% for a married couple with income up to $74,900; 15% for income in the middle; and 20% for 2015 taxable income above $464,850. In addition, there may be a 3.8% net investment tax if the property has been in passive or cash rental status for an extended period. And when a large capital gain is present, the Alternative Minimum Tax or AMT can push up the rate on other ordinary income. "Personal exemptions and itemized deductions can gradually phase out as income moves up the ladder," Hesse says.
This federal tax doesn't even count additional state income taxes which can run close to 10% in states such as New York and California, bringing the real worst-case scenario capital gains damages as high as 40% to 50%. Adding insult to injury, while the state tax paid is deductible against Federal taxable income, it might not provide a tax benefit due to the AMT.
If farmland owners choose to sell now in one lump payment, they will bump into these higher brackets. One alternative is to spread payments over several years to minimize their tax cost. For example, say Ted and Wilma, retired farmers who file jointly, normally report ordinary income and claim the standard deduction with two exemptions. They plan to sell farmland to his nephew, an active operator. The sale price is $1.1 million with a tax basis of $350,000, for a long-term capital gain of $750,000.
If the nephew pays cash up front, Ted and Wilma will owe $156,000 in federal taxes--capital gains, plus higher income taxes due to the AMT and the 3.8% Obama Care surcharge. On the other hand, they could save $51,624 in federal taxes, just by selling to their nephew on a three-year installment sale of land, Hesse calculated.
"Before anyone decides to sell land, they really need to consult a tax adviser first," Hesse said. "Depending on the seller's age and health, it might make more sense to hold onto the land and have capital gains forgiven at death. But if an installment sale fits the right circumstances, it can be a win-win for both parties."
To find the current IRS minimum rates on installment sales, go to http://apps.irs.gov/…
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