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This article was originally written for and published in The Business Bulletin.

Thoughts on taxes, trades, and turning stones...

My Dad used to talk about two of his friends arguing about whether it was better to be on the move or to stay in one place. One declared that “A rolling stone gathers no moss!” The other answered just as self-righteously “But a stone that stands still is never polished!”

So everybody has their own opinion, but the last 20 years or so have seen a lot of moving Mennonites. And I think it’s good for the most part. I support the colonization of new places and that we spread out the salt of the earth. So that’s why I think it’s time to discuss the tax complications that may arise with a move, particularly for those of you who own a farm or business.

You might think that if you are in business in one location, you could sell out and start up in another location without major tax problems, or by the same token, sell you farm and buy another farm to replace it, but that isn’t necessarily the case. So every so often I have these little surprise phone calls; and after a few niceties the bombshell is dropped. “How much tax would I have to pay if I sold my poultry operation for 990,000? We’re thinking about moving to that new congregation out in _____. We want to get out of the rat race, and slow down a little.”

My first reaction is to quote one of my witty relatives. “We left Kansas to get out of the rat race, but when we got to Texas the rats had babies!” But I’m getting off the subject… I’ll have to admit my stomach gets a little tight when this question comes up. With big numbers, I’m always afraid to give a tax estimate because of the risk of missing it by a long way. The “devil is in the details” certainly applies here, and we seldom know the details because we’re looking at the future.

Usually I start out by getting an estimate on how much the buildings will sell for, versus the house, versus the land, etc. Then I look at the depreciation schedule to see what the cost of those items are, and how much depreciation has been taken. I can run a few adding machine tapes and come up with a ballpark figure without too terribly much trouble. That figure usually brings some sort of negative reaction (see the example below) and invariably the next question comes up, “What are my options?” That’s what this article is about. I want you know that I’m not the authority on Section 1031 Tax Free Exchanges, aka, tax free exchanges, or just “trades,” my preferred term for this article. But I want to give you a few basics. First a couple of terms to get familiar with:

Capital Gain Income occurs when you sell as asset for more than you pay for it.

Depreciation Recapture is income that occurs when you sell as asset for equal or less than you paid for it, but have taken depreciation to bring your “basis” down below the sales price. Often you will have both of the above on the sale of the same asset.

It is important to know that you pay much more tax on Depreciation Recapture than you do on Capital Gain income. Realized Gain is the term used when you have Capital Gain or Depreciation Recapture. But it is not Recognized Gain unless you must pay tax on that income. In a trade you can defer all or part of the gain that was realized, instead of recognizing it as taxable income. What a twist?

Whether you realize it or not, you have likely all been involved in a Section 1031 exchanges. A simple example is when you trade your vehicle in for another one. Most of the time, you pay more for the newer vehicle than you are “allowed” for the older vehicle. We call that the “trade difference.” If you prefer not to strain your brain, you can skip this next section.

For example A let’s say I bought a 2001 Chevy Pickup for 15,000 in 2004. It is completely depreciated out, so I have taken all $15,000 as expense and my “basis” or “amount not deducted” is $0. If the dealer allows me $5,000 in trade for my 2001 pickup, I have $5,000 of depreciation recapture. (I have already deducted the entire $15,000 paid for the old pickup, but really the cost of owning that pickup was only $10,000 when the story was all told because I am getting $5,000 back). BUT, since I “traded,” I am not required to “recognize” that gain that I “realized.” Rather I can defer paying tax on it for now. I now reduce the cost of the new vehicle by the gain that I deferred on the old vehicle. So instead of putting the cost of my newer vehicle on depreciation for $25,000, I rather put it on for $20,000 (25,000 cost less the 5,000 deferred gain).

For example B let’s change the details a little. Let’s say I bought a 4020 John Deere new in 1965 for $7,500. By 1973 it was completely depreciated out so my cost basis left was $0. I took good care of that tractor and was surprised to get an offer for $10,500 for it from my local John Deere dealer when I traded it in on a newer tractor with a cost of $30,000. Again, we have a gain of $10,500 on that tractor because we had already taken all the expense. So we would have to add all that $7,500 of depreciation back into income because the total cost of the tractor was all used up and now we got all of our cost back. PLUS we have received $3,000 more for the tractor than what we paid for it in the beginning! So we also have capital gain (selling price over purchase price) of $3,000. BUT, once again, since we traded, we do not “recognize” any of the gain that we “realized.”

Now let’s look at our poultry farmer that wants to sell for $990,000. Oh well, let’s just go ahead and say $1M to keep it simple. Let’s assume that he bought the farm for $100,000 and put up 4 barns for $150,000 each 12 years ago. So his total cost was $700,000 (100,000 + [150,000 X 4]). He will have depreciated the $600,000 barns completely already, but the land could not be depreciated so he still has a basis of $100,000 in the operation. So, if he sells for $1M, he’s looking at realizing $900,000 worth of gain or profit. Of that gain, he’s going to have $600,000 worth of depreciation recapture, and $300,000 worth of capital gains. So he may pay upwards of $200,000 in federal taxes alone ([600,000 X 25%] + [300,000 X 15%]).

For some people, writing that kind of check to the government is way unacceptable! A side note here: Why don’t people ever think this way: “I am getting $1M for an operation that I put $700,000 for and after taxes I’ll still have $900,000?” In order to defer that gain with a tax free exchange, our friend will need to spend $1M on the new operation. This can sometimes be a difficult decision, especially for those who want to “get out of debt.” But, since he’s selling real estate, the rules are quite liberal about what he can purchase. In order to defer it all, he needs to spend as much as he was allowed for the old farm. Otherwise it will be a partially taxable trade. So, if he buys a farm for $1M and does a trade, he pays no tax, zip! But does he start all over depreciating the buildings, etc.? No, he carries the difference between cost and deferred gain to the new operation for his new basis. So since he deferred a total gain of $900,000, he has a basis of $100,000 left. Whether or not he has anything to depreciate depends on what type of operation he purchases.

But what if he still owes $250,000 on the new farm? Even that’s not a problem, since the loan on the new farm will be at least that much. The important part here is that everything is passed through the exchange agent and no money is received by the seller on the property to be exchanged. There are other rules too numerous and boring to mention here.

So are you lost in the details of all this? If so, don’t feel bad. Just understand that (a) there can be huge tax consequences to a move, (b) that you might be able to use a trade to reduce or eliminate tax and (c) your accountant needs to be included early on in your plans and yes, he does earn his fee.

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