The Tax Cuts and Jobs Act has changed the way farmers report trades of equipment, and it has the potential to impact tax liabilities in 2018 and into the future.
Before tax reform, equipment trades received Section 1031 deferral just like farm real estate trades, and the implications for trading equipment were minimal to a producer. Any difference between the trade-in value and the undepreciated basis was not recognized as taxable income; it was rolled into the new asset.
The rules have changed. Under tax reform, like-kind exchanges are limited to real property, so equipment no longer qualifies for non-recognition of income treatment. When trading equipment in 2018 and beyond, the producer is essentially selling the old piece for the trade-in credit granted by the dealer and will recognize income as a result.
Farmer Brown trades equipment
As an example, Farmer Brown has a combine worth $200,000 that has been fully depreciated. The farmer trades the combine and $300,000 for a new combine with a price of $500,000. Under the old law, there was no gain on the trade, and the tax cost basis was $300,000 (cash paid plus remaining basis in the old machine ― zero, since it was fully depreciated). Section 179 could have been used on the full $300,000, or 50 percent bonus depreciation could have been taken up to $150,000, with the balance of the cost basis being depreciated on a seven-year schedule.
Under the new law, the trade-in value of $200,000 becomes the sales price, and since the asset was fully depreciated, $200,000 of income is automatically added to Farmer Brown’s return. The new combine will be added to the depreciation schedule at the sticker price of $500,000 and can be depreciated over five-years (new equipment is depreciated over five years under tax reform), Section 179, or 100 percent bonus expensing.
If you were Farmer Brown, your natural inclination may be to depreciate the equipment so that the expense offsets the gain from the sale of the asset and reduces or eliminates income tax for the year. While this may produce a desirable short-term effect, you need to consider the long-term implications.
Reducing income tax may require giving up other tax benefits
Let's assume Farmer Brown's operations resulted in $200,000 of income before this equipment trade. Normal depreciation (not accelerated) for the new combine is reported on Schedule F where farm activity income is now $100,000. In addition, there is a $200,000 ordinary gain on the trade due to depreciation recapture. Section 179 could be used to zero out the farming operation income or take enough to offset the gain from the trade and the farming operation income (driving down taxable income close to zero).
For an active farmer, income from farm activity is reported on Schedule F and is subject to Social Security and Medicare taxes. Schedule F income is also used to determine the allowable deduction for business owner expenses, including health insurance and retirement contributions. Income from the sale of equipment (reported on Form 4797) is not considered for these deductions or for Social Security or Medicare.
Taking a depreciation expense to eliminate income is a tactic that appeals to many farmers. However, in choosing a complete offset of income using depreciation, Farmer Brown will give up the following tax benefits (assuming there are no other business activities on the return):
- For self-employment tax, any current year deductions below zero provide no future tax benefits.
- When there is no self-employment income, self-employed health insurance cannot be deducted, and no pension contribution is allowed.
Deciding among the options
The table below presents the tax results of three options related to the new piece of equipment.
Option A: Farmer Brown does not take accelerated depreciation in any form on the new machine, and as a result nets $100,000 of Schedule F farm income.
Option B: Farmer Brown utilizes just enough Section 179 to offset Schedule F income to $0.
Option C: Farmer Brown uses enough Section 179 to bring Schedule F to a loss that offsets the gain generated by the equipment sale.
While Option A results in nearly $56,000 in taxes, keep in mind that the decision to use depreciation is an exercise in timing. At some point, the producer will utilize the depreciation expense. In contrast, deductions for self-employed health insurance and pension contributions must be used annually or they will be lost. The 199A deduction also varies depending on the timing of depreciation. In Option B, the producer gives up $15,600 of income tax benefits (at the 24 percent rate), the majority of which cannot be recovered. In Option C, the producer gives up $12,600 in income tax benefits because the taxable income was reduced to the 12 percent bracket.
Tax Results for Three Depreciation Options
| Option A (no 179/bonus) | Option B (Section 179 to zero income) | Option C (Section 179 to offset gain) | |
|---|---|---|---|
| Spouse wages, other income | $50,000 | $50,000 | $50,000 |
| Farm income | $100,000 | - | ($200,000) |
| Gain on asset | $200,000 | $200,000 | $200,000 |
| Pension contribution* | ($20,000) | - | - |
| Self-employed health insurance* | ($25,000) | - | - |
| Standard deduction | ($24,000) | ($24,000) | ($24,000) |
| Tentative taxable income | $281,000 | $226,000 | $26,000 |
| 199A — 20 percent deduction* (calculated on the farm income plus ordinary gain on asset) | ($60,000) | ($40,000) | - |
| Adjusted taxable income | $221,000 | $186,000 | $26,000 |
| Income tax | $41,618 | $33,219 | $2,739 |
| Federal Insurance Contributions Act (FICA) tax | $14,130 | - | - |
| Total taxes | $55,748 | $33,219 | $2,739 |
| *Value of lost deductions based on tax bracket | No lost deductions | $15,600 | $12,600 |
The greater impact relates to Social Security and Medicare (FICA) taxes. A loss on Schedule F can be used to offset other current or future income tax items, but the ability to offset future FICA taxes is lost.
For instance, in Option C where a loss is created, Farmer Brown will pay a cumulative $19,781 more in FICA taxes than if the Section 179 depreciation deduction not been used in year one, and instead depreciated the asset over its life (assuming earnings are consistent at $100,000 before depreciation each year).
The bottom line is that making a decision only based on the taxes paid in one year could cost you more over time. Farmers are fortunate that they have the flexibility to adjust their income by deferring, depreciating, or prepaying business costs. But there are many variables to consider. Recognizing deferred tax obligations at this low tax rate and a 20 percent deduction environment may be a wise move. However, the volatile state of the commodity market may constrain cash flow, so it may also be important to mitigate taxes in order to cover debt obligations and family living expenses.
How we can help
As one can see, tax reform has created a greater level of complexity for producer tax filings. However, these changes may also provide opportunities. If routine equipment trades will continue to be a part of your work, it may be a good exercise to project the anticipated impact of your purchase and the anticipated deductions over time.
Planning during uncertain times is critical. There is no one ideal scenario that will work for every producer; but for most, failing to plan can result in unfortunate and unexpected consequences. Working with a tax advisor who understands how the new tax law affects the agriculture industry can help you avoid surprises later.