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Land sale taxes determined by asset allocation

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Buying or selling land is seldom a simple matter. When improvements exist on the land, questions arise concerning what portion of the transaction price is allocated to each improvement. Sellers and buyers often use different values depending on each one's individual tax situation. The reason for the attention given to allocation is that land cannot be depreciated, but many improvements used for business can be.

For the purposes of this article, the assumption is made that a land acquisition does not constitute the purchase of a total business or business entity. Those acquisitions can be much more complex and have specific tax reporting requirements. For brevity, this article will not discuss such business acquisitions or business entities.

When a buyer purchases land with improvements, e.g., a corral and fencing, the purchase price can be allocated between the land, the corral and the fencing. Fair market values (FMV) should be used to determine the basis or cost for each asset. Farm machinery and equipment, and agricultural fencing have a seven-year cost recovery period. If the buyer then sells the land after three years, the sales price needs to be divided among the land, corral and fence. Assuming the sales price is more than the original purchase price, the gain is taxed differently for the land than for the corral and fence.

The gain on the land is taxed at capital gain tax rates (0 percent if an individual is in the 10 or 15 percent tax bracket; 15 percent if an individual is in the 25, 28, 33 or 35 percent tax bracket; and 20 percent if an individual is in the 39.5 percent tax bracket). The gain on the corral and fence that is due to the depreciation taken is taxed at ordinary tax rates, which are generally higher than capital gain tax rates. The rest of the gain between the original purchase price of the corral and fencing, and the higher sales price qualifies for capital gain tax rates. Following is a theoretical example.

Table 1.

John and Mary purchase land with a corral and fencing for $300,000. The land and improvements are used in their ranching business. They determine the FMV of the corral is $20,000, and the perimeter and cross fencing has a FMV of $30,000. That leaves the fair market value of the land to be $250,000. Assume the total depreciation on the corral for the first three years is roughly $8,974, and the depreciation on the fencing is roughly $13,461. The appropriate annual amount would be deducted as depreciation expense on their Schedule F each year. In the fourth year after purchase, John and Mary receive an offer for $360,000 and decide to sell. During the three years of ownership, they did not add any additional improvements, deduct any soil and water conservation expenditures, or exclude any cost-sharing payments for conservation improvements. John and Mary agree with the buyers that the FMV of the corral is $24,000 and the FMV of the fencing is $36,000. The FMV of the land is $300,000.

How you allocate the purchase price in the year of purchase will have tax implications when the land is sold. All the gain that is due to depreciation is recaptured as ordinary income. This ordinary gain is taxed at regular rates based on an individual's tax bracket. On the other hand, all gain in the land and the gain on depreciable assets above the initial purchase price are taxed at capital gain tax rates, which are typically lower. Professionally qualified appraisers can help you allocate fair market values for land and improvements. For experts in your area, please visit asfmra.org or appraisalinstitute.org.

Dan Childs serves as a senior agricultural economics consultant at Noble Research Institute. After receiving his bachelor’s and master’s degrees in agricultural economics from Oklahoma State University, he served in the United States Army by working in the Pentagon. Before joining Noble in 1978, he spent time with the U.S. Department of Agriculture and Oklahoma State University Extension service. He and his wife own and operate a small stocker operation.