Is the Sale of Farm Land a Capital Gain or Ordinary Income?

Tax rules regarding the sale of farmland are complicated.
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As of 2013, the long-term capital gains rates range from 20 percent to 0 percent, based on you modified adjusted gross income. Long-term gains apply to property you've held for more than a year. You pay either capital gains rates or ordinary rates when you sell farmland, depending on what you've done with the land. The tax rules on farmland can be pretty complicated, so consult a tax specialist if you are unsure how to proceed.

Types of Property

You normally shell out capital gains taxes on property that you sell. This includes your investment securities, home, furnishings, cars and collectibles. The Internal Revenue Service taxes certain sales at ordinary income rates, including the sale of real property used in your trade or business. However, the sale of your farmland qualifies for capital gains tax under Section 1231 of the Internal Revenue Code if you used the land for farming and held it for more than one year. Farmland is considered Section 1252 property if you've improved it through conservation expenses. In this case, a portion of the sale profit is ordinary income. If you own non-working farmland as an investment, treat its sale as a capital gain or loss. If you sell working farmland within a year, treat the gain or loss as ordinary.

Tax Rates

Treat a loss on the sale of 1231 property as ordinary and report it on Part I of IRS Form 4797. Also treat as ordinary the portion of a gain resulting from 1231 losses that you've carried forward from the previous five years. The remaining part of the gain is taxed at long-term capital gains rates. If you've deducted conservation expenses on farmland you've held for more than one year but less than 10 years, you must treat a part of the sale amount as ordinary income under Section 1252. Report this on Part III of Form 4797. This amount is equal to a percentage of the total deductions you took for conservation expenses or to your entire gain, whichever is less. The percentage you apply depends on how long you've owned the land. For example, 100 percent of your conservation expenses get Section 1252 treatment for farmland that you've held for five years or less.

Conservation Expenses

If you use your farmland for farming, or rent the land to a farmer, you can deduct certain conservation expenses, including leveling, conditioning, grading or otherwise moving the earth around to improve the land. Other conservation expenses include diversion channels, ditches, dams, water features, planted windbreaks and brush removal. You can’t deduct the cost of draining or filling wetlands, though you can add these expenses to the cost basis of your land. The cost basis is the total amount you forked over when you bought the land. If your conservation expenses benefit both working and nonworking farmland, prorate and deduct the amount that applies to farmed land.

Section 1252 Example

Suppose you bought working farmland eight years ago and sell it this year for a gain of $30,000. You've spent and deducted $15,000 for conservation expenses. The percentage you can deduct for property you've held for eight years is 40 percent. To figure the portion of your gain that gets ordinary tax rates, multiply the conservation expense by the deductible percentage. In this example, the amount is 40 percent of $15,000, or $6,000. Treat this amount as a Section 1252 ordinary gain and the part left over, $24,000, as a Section 1231 capital gain. Report your gains and losses from the sale on IRS Form 4797.

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