Ask the Taxman by Andy Biebl

DTN Tax Columnist Andy Biebl is a CPA and principal with the accounting firm of CliftonLarsonAllen LLP in New Ulm and Minneapolis, Minn., a former president of the Minnesota Society of CPAs and a national authority on agricultural taxation. He writes for both DTN and our sister publication, The Progressive Farmer. To pose questions for upcoming columns, email AskAndy@dtn.com.

QUESTION:

In your recent Progressive Farmer article on "Winners and Losers in New Rental Tax," you mentioned that an installment sale may spread out the tax. But you didn't say that a taxpayer doing a 1031 exchange can defer the tax on the gain, along with the 3.8% investment income tax.

ANSWER:

You are absolutely correct. A Section 1031 exchange into other real estate defeats both the capital gain tax and the 3.8% net investment income tax. The replacement property must also be held for business or rental use (as opposed to personal use), but otherwise the like-kind test is not very stringent. For example, farm land can be exchanged into a commercial rental building, as well as into other farm land. If the farm you are surrendering has improvements that have been depreciated (bins, barns, drainage tile, irrigation systems), be careful of the depreciation recapture. Unless the replacement property has a similar amount of these types of assets, the exchange will not defeat the depreciation recapture.

For higher-income individuals, a 1031 exchange may be particularly beneficial, as they will be able to duck the 5% increase in the capital gain rate, and will also avoid the new 3.8% net investment income tax. For these individuals, the combined federal tax rate will approach 25%, and there may be a state income or capital gain tax as well. For those who are willing to continue to stay invested in real estate, the Section 1031 exchange can be a great solution. But for those looking to capture high land values or convert an illiquid real estate asset to cash, carefully structuring the sale, such as with the installment technique, will make sense.

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QUESTION:

Our firm assists several farmers, and we saw your article on the 3.8% tax. Our clients are active business owners. Is their business and land rental income not subject to the new 3.8% investment tax because it is subject to self-employment tax?

ANSWER:

The question of whether a landlord's rental income is subject to the self-employment tax is unchanged by the new 3.8% net investment income tax. Active business income from growing crops or raising livestock, of course, is subject to SE tax, as well as crop share and custom-farming income where the landowner is an active participant. These active business arrangements, where SE tax is already in play, are exempt by law from the new 3.8% net investment income tax. On the other hand, if the landowner is passive and reporting the rents as non-SE income, then any net rental income will generally be subject to the new 3.8% tax. But even here there is an exception: If the landowner rents the land to a business that he materially participates in and has ownership, the rent can be exempt from the 3.8% tax.

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QUESTION:

My wife and I are covered by Medicare and a supplemental policy. My former employer pays more than 50% of the cost of the supplement for my wife and myself. I still have active farm income under a custom farming arrangement and it is considered self-employment income. I have been told I cannot deduct the health insurance premiums because of the partial assistance from my former employer. But I have also been told I can deduct a separate premium I pay for long-term care insurance on the front page of my 1040. Is this advice accurate?

ANSWER:

The advice you have been given is correct. The Form 1040 page 1 deduction for 100% of health insurance has a number of restrictions. One of those denies the deduction if the taxpayer is eligible to participate in any subsidized health plan. But that rule applies separately for qualified long-term care insurance contracts. So your basic health insurance supplement and Medicare premiums are not deductible due to the former employer subsidy, but your long-term care insurance premiums are deductible.

There is one other possibility for the Medicare B premiums and portion of the supplement that you pay out of your pocket. Those expenses still qualify for the Schedule A itemized deduction for medical costs. However, you will find that there is an income floor of 7.5% of AGI if either spouse has attained age 65 by year end.

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QUESTION:

I am an attorney who has a client that would like to sell a conservation easement and exchange those funds into new farm land. The proceeds on the conservation easement are well above his basis in the land. Could this meet the like-kind 1031 exchange definition?

ANSWER:

There are five Private Letter Rulings, issued by the IRS between 1992 and 2002, that all affirm this type of transaction. The key is that the conservation easement proceeds are paid to the taxpayer for a permanent easement on the old property. The landowner is technically retaining title to the old property, but the easement payment, when perpetual, is considered the equivalent of surrendering an interest in real estate that qualifies for like-kind exchange treatment. These private rulings rely on a full Revenue Ruling from 1972 (Rev Rul 72-549), and should represent sufficient authority to proceed with your transaction.

Andy Biebl can be reached at AskAndy@dtn.com

(MZT/AG/SK)

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