Tax-Free Equipment Exchanges Gone But Might Not Matter (In Most Cases)

I have gotten several questions on equipment 1031 exchanges.  Under both the House and the Senate Proposals, 1031 exchanges would only be allowed for real property.  Many farmers are concerned that if they exchange their equipment, that this will no longer be tax-free.  The answer is yes, it is not tax-free, but it might not matter.

In order to have a 1031 equipment exchange, you must have both a sale and then a purchase of equipment of equal or greater value to be a valid tax-deferred exchange.  The House Bill would allow you to deduct 100% of your equipment purchases for the next five years and after that point, Section 179 would increase to $5 million which would cover most farm equipment purchases.  The Senate is not quite as nice.  They bump Section 179 to $1 million starting next year, but only allow 100% bonus depreciation on new equipment, not used equipment.

Let’s look at some examples.

Farmer Smith exchanges a tractor worth $100,000 (fully depreciated) for a new tractor that costs $300,000.  His cash out-of-pocket is $200,000.  Under current law, there is no gain on the exchange of the old tractor and Farmer Smith gets to take Section 179 on the $200,000 of cash paid (or take bonus and depreciate the rest).  Under the House Bill, he would recognize $100,000 of income on the exchange (but not subject to self-employment tax) and then be allowed to fully depreciate the $300,000 cost of the new tractor (reducing SE income).  This is actually better for all sole proprietor farmers than current law.  The Senate would allow the same thing for new equipment for the next five years.  If it is used equipment, you then have to take Section 179 to write off the new piece of equipment in full.

Generally, this is the treatment; however, there is at least one situation where this is not as generous.  Suppose Farmer Smith exchanges his tractor using a tax-deferred exchange and sells his tractor for $100,000 on December 29 and then buys a new tractor for $300,000.  In this situation, he recognizes gain in year 1, but can’t deduct until the next year.

Deemed Rate of Return and Interest Expense

The House Bill does have the provision that allows a farmer to treat 30% of his farm income subject to the maximum 25% tax rate or they can apply the deemed rate of return calculation if that would lower their tax bill.  However, this calculation requires you to reduce the amount allowed by any interest expense paid and locks you into this calculation for five years.  Let’s look at a couple of examples:

Farmer Jones has adjusted basis in his farm equipment of $1 million.  The deemed rate of return is 7% plus the S/T AFR rate of let’s assume 1% for a total deemed rate of return of 8%.  Therefore, up to $80,000 of farm income may be subject to the lower 25% tax rate.  Now, if he has leveraged this equipment and pays $40,000 of interest, this would drop the amount he can have taxed at the 25% rate to only $40,000.  If he earned $200,000, under the 70/30 rule, he could have $60,000 taxed at 25% which is $20,000 more than the deemed rate of return calculation.

Now, let’s assume the farm equipment was fully depreciated and he did not owe any debt on the equipment.  Under this situation, none of the income is allowed for the 25% top rate.  Since you are locked in for five years using this method and interest expense deducted will reduce the income subject to the lower rate, care must be taken in deciding which is best.

Now, none of this may happen, but we just want to keep you posted on what might happen.

 

 

  • Principal
  • CliftonLarsonAllen
  • Yakima, Washington
  • 509-823-2920

Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a partner with CliftonLarsonAllen in Yakima, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. In fact, Paul drives combine each summer for his cousins and that is what he considers a vacation.

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Comments

Paul,
Read your post of 11/15 regarding the rate of return calculation. Looks like you are using just the basis of the farm equipment in the calculation or does the term farm equipment include other items such a farm buildings, silos, land, etc?
Al Nietzke

I’m left wondering yet again what these people in Washington are thinking about and whom they are thinking of when they draft these bills. At least the SE tax mess *seems* to have worked itself out. These fools seem determined to cost us thousands of additional dollars in taxes on the same income and then have the audacity to tell us we’re better off.

We will have some real issues if the states do not follow.
May create big negative incomes where the 179 differences are carried forward (MN) which will never be used up. We are seeing that now with lower commodity prices and large amounts of 179 used in the previous high income year.

Thank you Paul. To understand the long-term impact, one should further look at years 6-10 when 100% expensing is set to expire along with the increased Sect 179. Historically we see a majority of the States non-conform to federal expensing provisions. The Senate Bill contemplates increasing the pass-thru rate as well in 5 years. All of this coupled with the immediate and permanent repeal of LKEs (no more tax-free trade ins on farm equipment) at both the Federal and State level should force businesses to understand cash flow impacts after 5 years. That is where our economy will hit a wall.

Paul – appreciate your analysis. Very helpful for planning our tax scenarios.

Puts those who buy used and have little debt at a disadvantage! Reading the comments in the WSJ people are sure pass through entities are the play toys for the rich to hide cash- might explain some of the illogical and complicated schemes devised in the house bill – 30/70 or deemed rate of return. Neither simplifies and more accurately reflects the wrong imposed on small business. At least they changed the SE tax mess in the original. Hard to support either senate or house bill given the track record to fix things!

will this law go into effect in 2017 or 2018… talking about the exchange on machinery & vehicles

Will this law go into effect for 2017 or 2018 …. talking about the no 1031 exchange on machinery and vehicles

Not exactly the much balihooed “simplification”

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