1245 Not 1231

There are two types of gain when farmers sell farm equipment. Most of the time, the gain will be what we call Section 1245 gain. This gain is taxed at ordinary income tax rates and will qualify for the new Section 199A 20% tax deduction. This gain is a result of recapturing tax depreciation that has been taken on the equipment.

If the piece of equipment is sold for more than original cost, this excess gain is called Section 1231 gain and is taxed at capital gains rates, but is not eligible for the Section 199A deduction (at least based on proposed regulations).

Here is an example:

Judy purchases a tractor for $250,000. She depreciates the tractor down to $50,000. She then sells the tractor for $150,000. The gain of $100,000 is Section 1245 gain and is taxed at regular rates, but she may be able to take a further $20,000 Section 199A deduction resulting in net total gain of $80,000. Now, let’s assume she only paid $100,000 for the tractor. The Section 1245 gain is $50,000 and the Section 1231 gain is $50,000. The Section 199A deduction will be $10,000 for net ordinary income of $40,000 and capital gain income of $50,000.

Now if the farmer sells a piece of farm equipment that was originally traded-in on another piece of farm equipment the calculation of 1245/1231 can get tricky. In many cases, the amount of 1245 gain is understated and the amount of 1231 gain is overstated. 1231 gain does not start until the equipment is sold for more than the original cost of the equipment, not the adjusted tax basis of the equipment.

Here is an example:

Judy traded a tractor worth $100,000 on a new tractor worth $200,000. She had fully depreciated the tractor, so her adjusted tax basis in the tractor is $100,000. She fully depreciates the new tractor and then sells it for $150,000. Many farmers assume that they have $100,000 of Section 1245 recapture and $50,000 of Section 1231 gain since they sold it for more than the adjusted tax basis. The correct answer is $150,000 of 1245 recapture. There is no 1231 gain until you sell the tractor for more than $200,000.

There are many instances where extra Section 1231 gain has been picked up on “traded” equipment. Since you can no longer do a 1031 deferred gain on these transactions, much of this extra gain will disappear over the next few years.

  • Principal
  • CliftonLarsonAllen
  • Walla Walla, 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 principal with CliftonLarsonAllen in Walla Walla, 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. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.

Comments

There are issues with trade in of farm pickups treated 75% for business. When the 25% personal portion of the trade in value is separated out as the sales price, and “cost” as carried in depreciation systems from the last “boot’ paid, some trades are showing a personal gain. It would appear that is reportable, but seems a pretty harsh treatment. Any comments for going back in to look at full 25% of last purchased asset cost, rather that last amount of boot paid?

This can always be an issue. The personal portion does not qualify for an exchange, but is part of the “trade-in” value.

In your second example, the FMV was $100,000 but ATB was $0 due to prior depreciation. The second tractor was FMV of $200,000 but ATB of $0 again due to prior depreciation. I agree with your 1245 recapture of $150,000 of the selling price. Could you confirm that this scenario, you will not have 1231 gain until the selling price exceeds the amount of the cost of the first plus the cost of the second.

It is really related to the cost of the asset sold based on the original purchase price before any trade-in values.

i am concerned about this problem. Irs will only know what is on the current forms, and the trades will not be followed due to 179 . This will also cause problems for state income taxes as well. My next problem with this is sale of property such as single purpose structures. For the above problem do we do 1245 or 1250?

Single purpose Ag structures are 1245 real estate not 1250. However, they can be exchanged into other 1245 real property.

I see the problem – our tax software will only have the basis after the trade of the equipment, therefore causing 1231 capital gains to calculate on the sale where it should be 1245 ordinary income. This can have a significant impact on a tax return.

You will just need to override the depreciation number, etc. to get it correct.

How do preparers realistically obtain the information you outline in your post to properly calculate the character of the gain? Will this require that we dig through old files or request equipment contracts from previous purchases, which could potentially be several years old?
Do you anticipate most tax preparers making the effort to obtain this information?
Are you making the point in your last paragraph that you don’t suspect most preparers will go to the extra effort and thus, the S. 1231 gain will be overstated and eventually over time as this equipment with low tax basis is traded/sold the problem will be corrected?

I would only look at the current cost of the piece of machinery being sold. That price should be entered somewhere on the memo line of the depreciation schedule or you may have to look at the paperwork on the original trade. You will not have 1231 gains until you sell it for more than that cost.