I know, tax law. It’s a super sexy topic that’s easy to understand and fun to talk about. Well, maybe not. But farmers are seriously concerned about the proposed changes floating around Washington, D.C. So it’s worth understanding the issues and why it’s such a big deal.
This is my attempt to make an easy-to-understand explanation. I’ll admit I’m not an accountant, and my understanding of these terms comes more from a legal perspective (note: this is NOT legal advice). But I hope it’ll at least provide some working knowledge of capital gains. So here we go!
What are capital gains taxes?
Capital gains taxes are due when certain property–such as land, buildings, livestock, or timber–are sold. We refer to the original price tag of the property as the “basis.” If the property owner later sells the property for more than she paid for it, the amount of above the basis is taxed. In other words, the government assesses capital gains taxes on any “profit” made when the property is sold. Currently the tax rate is 23.8 percent.
Let’s take an example. Farmer purchases greenacre, a 40-acre piece of land, in 2000 for $100,000. The basis is $100,000; the price Farmer paid for the property. In 2010, Farmer sells that land to his neighbor for $150,000. Farmer realized a profit of $50,000; he received $50,000 over what he bought greenacre for in 2000. The government taxes that $50,000 at 23.8 percent. So Farmer has to pay about $12,000 in capital gains taxes when he sells greenacre.
Still with me? Let’s talk about what happens when Farmer A still owns the property at his death.
What is the step-up in basis?
Remember the basis? (Remember: that’s the amount that a person purchased the property for.) Currently, if a person still owns property at their death, and an heir inherits the property, the heir receives what we call a “step-up in basis.” That means the heir’s basis is raised to the fair-market value at the time of inheritance.
Let’s continue with our example. Farmer buys greenacre for $100,000 in 2000. Just like before, his basis in the property is $100,000. This time Farmer dies in 2010 while still owning greenacre. Farmer’s Daughter inherits greenacre at his death, when the property is valued at $150,000. Daughter’s basis is now $150,000, because she gets a step-up in basis by inheriting the property. In other words, it’s like Daughter purchased the property when she inherited it. So when she goes to sell the property in 2020 for $200,000, she’s only paying capital gains taxes on $50,000 (the amount of “profit” she gets above her basis).
Makes sense; right? The point is that Daughter gets a step-up in basis when she inherits the property.
What happens if Daughter didn’t get the step-up in basis when she inherited the property? So Farmer buys the property for $100,000 in 2000. In 2010, he dies and leaves the property to Daughter. We have no step-up in basis, so the basis is still $100,000, even though the property is worth $150,000. In 2020, Daughter goes to sell the property for $200,000. Daughter will have to pay capital gains on $100,000–the difference between the price Farmer paid for it and the price Daughter sell its for. At the current rate, Daughter will owe about $24,000 in taxes.
Why does that matter to farmers?
U.S. agriculture has a legacy of mutli-generational family farming. My brothers and I are the fourth generation on our farm. You can imagine when you have multiple generations, the same land may be inherited several times without being sold. If that happens, getting a step-up in basis is critical.
Let’s take a new example. Grandparents buy the farm in 1950 for $20,000. In 2000, Farmer inherits the farm, which is now worth $100,000. In 2020, Farmer dies and Daughter inherits the farm, which is now worth $200,000. Because the current law allows Daughter a step-up in basis, her basis in the farm is $200,000. But if she didn’t get a step-up in basis, the basis would be $20,000–the original price her grandparents paid for the farm!
Without the step-up in basis, Daughter won’t want to sell it. Why? Because she’ll be paying a significant amount in capital gains taxes! In our scenario, if she sells it shortly after inheriting it, she’ll owe over $40,000 in taxes. The longer that chain of inheritance goes, the higher and higher those taxes become.
And that hits agriculture particularly hard because it’s a land-dense business. We need acres to farm. Without the step-up in basis, non-farmers may be unwilling to sell farmland because they don’t want to pay so much in taxes. That can make it extremely hard for landless young farmers to get started. And it also locks farmers into the land they own. Sometimes selling one piece of property and purchasing another makes good business sense. But without a step-up in basis, that’s not possible.
That’s why farm organizations like the American Farm Bureau Federation oppose any type of capital gains tax. It unfairly hits farmers, ranchers, and other land-intensive businesses hardest. And it limits opportunities to get into (and out of!), these businesses.
So there’s your super-simple, totally-not-hard introduction to capital gains! As tax policy is debated over the coming weeks and months, keep this idea in mind.
Jim Orr says
Thanks for the article Amanda!
A couple comments from a farmer and tax preparer. This is also not tax advice. Please consult your tax advisor before making significant financial decisions.
The 23.8% tax rate that you mentioned is a combination of the maximum 20% rate on long term capital gain (assets held over a year) and the 3.8% NIIT (Net Investment Income Tax) on investment income if your AGI exceeds a separate threshold based on your filing status.
There are actually three long term capital gain rates, depending on your filing status and taxable income. They are 0%, 15%, and 20%.
I understand that you kept things simple to to make you points and appreciate that this can get complicated very quickly. I just wanted to clarify that you were combining two taxes and that it’s not just one rate.
On the step-up in basis, the income that is being passed to the heirs has been subjected to the estate tax prior to the heirs getting that money/property. I have always felt like this is part of the reason for the step-up. I look at it the same way as a person that makes less than the standard deduction wouldn’t pay any income tax but, they are allowed to contribute their “after tax dollars” to a Roth IRA even if the tax was $0. If the estate exemption for the decedent is more than their assets, the effective tax rate is 0% but, the estate assets hve been “taxed” at their fair market value and thus the heirs are given a basis equal to the fair market value that the “tax” was paid on. I haven’t looked at the actual code to see if this connection exists formally, but like a lot of things, this is how I have made sense of it.
On another note, there is a tax provision for business or investment property (currently only real property, i.e. land and buildings) called Section 1031 Exchange, where you can do a tax free exchange of your property for another property. This doesn’t work in all cases (can’t find a match), can be quite complicated, and the IRS is very strict about the process and you rarely find an exact exchange of equal value, so one party often pays some tax on the difference. This only applies to assets that are currently held for business or investment use and the new property is going to be used for business or investment.
With all of this said, I agree with (my interpretation of) your point that higher tax rates affect the free flow of capital to its best use.
Thanks again for all the work you do advocating for agriculture.
Thanks so much, Jim! It’s good to know my explanation at least mostly passed muster of a professional!