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Pub. 225, Farmer's Tax Guide 2004 Tax Year

Chapter 9 - Dispositions of Property Used in Farming

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Table of Contents

Introduction

When you dispose of property used in your farm business, your taxable gain or loss is usually a section 1231 gain or loss. Its treatment as ordinary income (which is taxed at the same rates as wages and interest income) or capital gain (which is generally taxed at lower rates) is determined under the rules for section 1231 transactions.

When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any gain remaining after applying the depreciation recapture rules is a section 1231 gain, which may be taxed as a capital gain.

Gains and losses from property used in farming are reported on Form 4797. Table 9-1 contains examples of items reported on Form 4797 and refers to the part of that form on which they first should be reported. Chapter 15, Sample Return, contains a sample filled-in Form 4797.

Topics - This chapter discusses:

  • Section 1231 gains and losses

  • Depreciation recapture

  • Other gains

Useful Items - You may want to see:

Publication

  • 544 Sales and Other Dispositions
    of Assets

Form (and Instructions)

  • 4797
    Sales of Business Property

See chapter 16 for information about getting publications and forms.

Section 1231 Gains and Losses

Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions—generally, dispositions of property used in business. Their treatment as ordinary or capital, generally, depends on whether you have a net gain or a net loss from all your section 1231 transactions in the tax year.

Table 9-1. Where To First Report Certain Items on Form 4797

Type of property Held 1 year
or less		 Held more than
1 year
1 Depreciable trade or business property:    
  a Sold or exchanged at a gain Part II Part III (1245, 1250)
  b Sold or exchanged at a loss Part II Part I
2 Farmland held less than 10 years for which soil, water, or land clearing expenses were deducted:    
  a Sold at a gain Part II Part III (1252)
  b Sold at a loss Part II Part I
3 All other farmland Part II Part I
4 Disposition of cost-sharing payment property described in section 126 Part II Part III (1255)
5 Cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less
than 24 mos.		 Held 24 mos.
or more
  a Sold at a gain Part II Part III (1245)
  b Sold at a loss Part II Part I
  c Raised cattle and horses sold at a gain Part II Part I
6 Livestock other than cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less
than 12 mos.		 Held 12 mos.
or more
  a Sold at a gain Part II Part III (1245)
  b Sold at a loss Part II Part I
  c Raised livestock sold at a gain Part II Part I

Caution
If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation recapture rules (explained later). Do not take that gain into account as section 1231 gain.

Section 1231 transactions.   Gain or loss on the following transactions is subject to section 1231 treatment.

  • Sale or exchange of cattle and horses. The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and held for 2 years or longer.

  • Sale or exchange of other livestock. This livestock must be held for draft, breeding, dairy, or sporting purposes and held for 1 year or longer. Other livestock includes hogs, mules, sheep, and goats, but does not include poultry.

  • Sale or exchange of depreciable personal property. This property must be used in your business and held longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade or business. Examples of depreciable personal property include farm machinery and trucks. It also includes amortizable section 197 intangibles.

  • Sale or exchange of real estate. This property must be used in your business and held longer than 1 year. Examples are your farm or ranch (including barns and sheds).

  • Sale or exchange of unharvested crops. The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person, and the land must have been held longer than 1 year. You cannot keep any right or option to reacquire the land directly or indirectly (other than a right customarily incident to a mortgage or other security transaction). Growing crops sold with a lease on the land, even if sold to the same person in a single transaction, are not included.

  • Distributive share of partnership gains and losses. Your distributive share must be from the sale or exchange of property listed earlier and held longer than 1 year (or for the required period for certain livestock).

  • Cutting or disposal of timber. You must treat the cutting or disposal of timber as a sale, as described in chapter 8 under Timber.

  • Condemnation. The condemned property (defined in chapter 11) must have been held longer than 1 year. It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be property held for personal use.

  • Casualty or theft. The casualty or theft must have affected business property, property held for the production of rents or royalties, or investment property (such as notes and bonds). You must have held the property longer than 1 year. However, if your casualty or theft losses are more than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. Section 1231 does not apply to personal casualty gains and losses. See chapter 11 for information on how to treat those gains and losses.

Property for sale to customers.   A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction. If you will get back all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property held mainly for sale to customers.

Treatment as ordinary or capital.   To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the year.

  • If you have a net section 1231 loss, it is an ordinary loss.

  • If you have a net section 1231 gain, it is ordinary income up to your nonrecaptured section 1231 losses from previous years, explained next. The rest, if any, is long-term capital gain.

Nonrecaptured section 1231 losses.   Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain by treating the gain as ordinary income. These losses are applied against your net section 1231 gain beginning with the earliest loss in the 5-year period.

Example.

In 2004, Ben has a $2,000 net section 1231 gain. To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period. From 1999 through 2003 he had the following section 1231 gains and losses.

Year Amount
1999 -0-
2000 -0-
2001 ($2,500)
2002 -0-
2003 $1,800

Using this information, Ben figures how to report his net section 1231 gain for 2004 as shown below.

1) Net section 1231 gain (2004) $2,000
2) Net section 1231 loss (2001) ($2,500)  
3) Net section 1231 gain (2003) 1,800  
4) Remaining net section
1231 loss 		($700)  
5) Gain treated as
ordinary income 		$700
6) Gain treated as long-term
capital gain		 $1,300

His remaining net section 1231 loss from 2001 is completely recaptured in 2004.

Depreciation Recapture

If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if it is otherwise nontaxable) as ordinary income.

Section 1245 Property

A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable. See Gain Treated as Ordinary Income, later.

Any recognized gain that is more than the part that is ordinary income because of depreciation is a section 1231 gain. See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier.

Defined.   Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and is any of the following types of property.

  1. Personal property (either tangible or intangible).

  2. Other tangible property (except buildings and their structural components) used as any of the following.

    1. An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services.

    2. A research facility in any of the activities in (a).

    3. A facility in any of the activities in (a) for the bulk storage of fungible commodities.

  3. That part of real property (not included in (2)) with an adjusted basis reduced by certain amortization deductions (including those for certified pollution control facilities, childcare facilities, removal of architectural barriers to persons with disabilities and the elderly, or reforestation expenses) or a section 179 deduction.

  4. Single purpose agricultural (livestock) or horticultural structures.

  5. Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Buildings and structural components.   Section 1245 property does not include buildings and structural components. The term building includes a house, barn, warehouse, or garage. The term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc.

  Do not treat a structure that is essentially machinery or equipment as a building or structural component. Also, do not treat a structure that houses property used as an integral part of an activity as a building or structural component if the structure's use is so closely related to the property's use that the structure can be expected to be replaced when the property it initially houses is replaced.

  The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. Structures such as oil and gas storage tanks, grain storage bins, and silos are not treated as buildings, but as section 1245 property.

Facility for bulk storage of fungible commodities.   This is a facility used mainly for the bulk storage of fungible commodities. Bulk storage means storage of a commodity in a large mass before it is used. For example, if a facility is used to store sorted and boxed oranges, it is not used for bulk storage. To be fungible, a commodity must be such that one part may be used in place of another.

Gain Treated as Ordinary Income

The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts.

  1. The depreciation and amortization allowed or allowable on the property.

  2. The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property).

For any other disposition of section 1245 property, ordinary income is the lesser of (1) above or the amount by which its fair market value is more than its adjusted basis. For details, see chapter 3 of Publication 544.

Use Part III of Form 4797 to figure the ordinary income part of the gain.

Depreciation claimed on other property or claimed by other taxpayers.   Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts.

  • Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion. For details on exchanges of property that are not taxable, see Like-Kind Exchanges in chapter 8.

  • Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift).

Example.

Jeff Free paid $120,000 for a tractor in 2002. He depreciated it using the 150% declining balance method. The tractor is 7-year property. On February 23, 2004 he traded it for a chopper and paid an additional $30,000. To figure his depreciation deduction for the current year, Jeff continues to use the basis of the tractor as he would have before the trade to depreciate the chopper. Because this is the third year of depreciation, he takes a deduction of $18,036 ($120,000 × .1503).

Jeff can also depreciate the additional $30,000 basis on the chopper. Because this is the first year of depreciation on the $30,000, he takes a depreciation deduction of $3,213 ($30,000 × .1071). The total depreciation he can deduct for 2004 is $21,249 ($18,036 + $3,213).

caution
Temporary regulations were issued to provide more flexibility for computing depreciation deductions when property is acquired in a like-kind exchange. For details, see chapter 7 and the instructions for Form 4562.

Depreciation and amortization.   Depreciation and amortization deductions that must be recaptured as ordinary income include (but are not limited to) the following items.

  1. Ordinary depreciation deductions.

  2. Section 179 deduction (see chapter 7).

  3. Any special depreciation allowance.

  4. Amortization deductions for all the following costs.

    1. Acquiring a lease.

    2. Lessee improvements.

    3. Pollution control facilities.

    4. Reforestation expenses.

    5. Section 197 intangibles.

    6. Childcare facility expenses incurred before 1982.

    7. Franchises, trademarks, and trade names acquired before August 11, 1993.

  5. Deductions for all the following costs.

    1. Removing barriers to the disabled and the elderly.

    2. Tertiary injectant expenses.

    3. Depreciable clean-fuel vehicles and refueling property (minus any recaptured deduction).

  6. Any basis reduction for the investment credit (minus any basis increase for a credit recapture).

  7. Any basis reduction for the qualified electric vehicle credit (minus any basis increase for a credit recapture).

Example.

You file your returns on a calendar year basis. In February 2002, you bought and placed in service for 100% use in your farming business a light-duty truck (5-year property) that cost $10,000. You used the half-year convention and your MACRS deductions for the truck were $1,500 in 2002 and $2,550 in 2003. You did not claim the section 179 expense deduction for the truck. You sold it in May 2004 for $7,000. The MACRS deduction in 2004, the year of sale, is $893 (½ of $1,785). Figure the gain treated as ordinary income as follows.

1) Amount realized $7,000
2) Cost (February 2002) $10,000  
3) Depreciation allowed or allowable (MACRS deductions: $1,500 + $2,550 + $893) 4,943  
4) Adjusted basis (subtract line 3
from line 2) 		$5,057
5) Gain realized (subtract line 4
from line 1) 		1,943
6) Gain treated as ordinary income
(lesser of line 3 or line 5)		 $1,943

Depreciation allowed or allowable.   You generally use the greater of the depreciation allowed or allowable when figuring the part of gain to report as ordinary income. If, in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method.

  This treatment applies only when figuring what part of the gain is treated as ordinary income under the rules for section 1245 depreciation recapture.

Disposition of plants and animals.   If you made the choice not to apply the uniform capitalization rules (see chapter 6), you must treat any plant you produce as section 1245 property. If you have a gain on the property's disposition, you must recapture the preproductive expenses you would have capitalized if you had not made the choice by treating the gain, up to the amount of these expenses, as ordinary income. For section 1231 transactions, show these expenses as depreciation on Form 4797, Part III, line 22. For plant sales that are reported on Schedule F, this recapture rule does not change the reporting of income because the gain is already ordinary income. You can use the farm-price method or the unit-livestock-price method discussed in chapter 2 to figure these expenses.

Example.

Janet Maple sold her apple orchard in 2004 for $80,000. Her adjusted basis at the time of sale was $60,000. She bought the orchard in 1997, but the trees did not produce a crop until 2000. Her preproductive expenses were $6,000. She chose not to apply the uniform capitalization rules. Janet must treat $6,000 of the gain as ordinary income.

Section 1250 Property

Section 1250 property includes all real property subject to an allowance for depreciation that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not section 1250 property because it is not depreciable.

Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable. To determine the additional depreciation on section 1250 property, see Additional Depreciation, later.

You will not have additional depreciation if any of the following apply to the property disposed of.

  • You figured depreciation for the property using the straight line method or any other method that does not result in depreciation that is more than the amount figured by the straight line method and you have held the property longer than 1 year.

  • You chose the alternate ACRS (straight line) method for the property, which was a type of 15-, 18-, or 19-year real property covered by the section 1250 rules.

  • The property was nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made) and you held it longer than 1 year. These properties are depreciated using the straight line method.

Additional Depreciation

If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. For a list of items treated as depreciation adjustments, see Depreciation and amortization under Section 1245 Property, earlier.

If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation.

Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life.

The straight line method is applied without any basis reduction for the investment credit.

Depreciation claimed by other taxpayers or claimed on other property.   Additional depreciation includes all depreciation adjustments to the basis of section 1250 property whether allowed to you or another person (as for carryover basis property).

Depreciation allowed or allowable.   You generally use the greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) when figuring the part of the gain to be reported as ordinary income. If you can show that the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation.

Applicable Percentage

The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is nonresidential real property, residential rental property, or low-income housing. The applicable percentage for nonresidential real property is explained next. The applicable percentages for residential rental property and low-income housing are explained in chapter 3 of Publication 544.

Nonresidential real property.   For real property that is not residential rental property, the applicable percentage for periods after 1969 is 100%. For periods before 1970, the percentage is zero and no ordinary income will result from its disposition because of additional depreciation before 1970.

More information.   For more information about depreciation recapture on section 1250 property, see chapter 3 of Publication 544.

Gain Treated as Ordinary Income

To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.

  1. In a sale, exchange, or involuntary conversion of the property, figure the amount realized that is more than the adjusted basis of the property. In any other disposition of the property, figure the fair market value that is more than the adjusted basis.

  2. Figure the additional depreciation for the periods after 1975.

  3. Multiply the lesser of (1) or (2) by the applicable percentage, discussed earlier. Stop here if (2) is equal to or more than (1). This is the gain treated as ordinary income because of additional depreciation for the periods after 1975.

  4. Subtract (2) from (1).

  5. Figure the additional depreciation for periods after 1969 but before 1976.

  6. Add the lesser of (4) or (5) to the result in (3). This is the total gain treated as ordinary income because of additional depreciation.

Use Part III, Form 4797, to figure the ordinary income part of the gain.

Installment Sale

If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.

If you dispose of more than one asset in a single transaction, you must separately figure the gain on each asset so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain.

For more information on installment sales, see chapter 10.

Other Dispositions

Chapter 3 of Publication 544 discusses the tax treatment of the following transfers of depreciable property.

  • By gift.

  • At death.

  • In like-kind exchanges.

  • In involuntary conversions.

Publication 544 also explains how to handle a single transaction involving multiple properties.

Other Gains

This section discusses gain on the disposition of farmland for which you were allowed either of the following.

  • Deductions for soil and water conservation expenditures (section 1252 property).

  • Exclusions from income for certain cost sharing payments (section 1255 property).

Section 1252 property.   If you disposed of farmland you held more than 1 year and less than 10 years at a gain and you were allowed deductions for soil and water conservation expenses for the land, as discussed in chapter 5, you must treat part of the gain as ordinary income and treat the balance as section 1231 gain.

Exceptions.   Do not treat gain on the following transactions as gain on section 1252 property.

  • Disposition of farmland by gift.

  • Transfer of farm property at death (except for income in respect of a decedent).

For more information, see section 1.1252-2 of the regulations.

Amount to report as ordinary income.   You report as ordinary income the lesser of the following amounts.

  • Your gain (determined by subtracting the adjusted basis from the amount realized from a sale, exchange, or involuntary conversion, or the fair market value for all other dispositions).

  • The total deductions allowed for soil and water conservation expenses multiplied by the applicable percentage, discussed next.

Applicable percentage.   The applicable percentage is based on the length of time you held the land. If you dispose of your farmland within 5 years after the date you got it, the percentage is 100%. If you dispose of the land within the 6th through 9th year after you got it, the applicable percentage is reduced by 20% a year for each year or part of a year you hold the land after the 5th year. If you dispose of the land 10 or more years after you got it, the percentage is 0%, and the entire gain is a section 1231 gain.

Example.

You acquired farmland on January 19, 1997. On October 3, 2004, you sold the land at a $30,000 gain. Between January 1 and October 3, 2004, you make soil and water conservation expenditures of $15,000 for the land that are fully deductible in 2004. The applicable percentage is 40% since you sold the land within the 8th year after you got it. You treat $6,000 (40% of $15,000) of the $30,000 gain as ordinary income and the $24,000 balance as a section 1231 gain.

Section 1255 property.   If you receive certain cost-sharing payments on property and you exclude those payments from income (as discussed in chapter 3), you may have to treat part of any gain as ordinary income and treat the balance as a section 1231 gain. If you chose not to exclude these payments, you will not have to recognize ordinary income under this provision.

Amount to report as ordinary income.   You report as ordinary income the lesser of the following amounts.

  • The applicable percentage of the total excluded cost-sharing payments.

  • The gain on the disposition of the property.

You do not report ordinary income under this rule to the extent the gain is recognized as ordinary income under sections 1231 through 1254, 1256, and 1257 of the Internal Revenue Code. However, you do report as ordinary income under this rule a gain or a part of a gain regardless of any contrary provisions (including nonrecognition provisions) under any other section of the Internal Revenue Code.

Applicable percentage.   The applicable percentage of the excluded cost-sharing payments to be reported as ordinary income is based on the length of time you hold the property after receiving the payments. If the property is held less than 10 years after you receive the payments, the percentage is 100%. After 10 years, the percentage is reduced by 10% a year, or part of a year, until the rate is 0%.

Form 4797, Part III.   Use Form 4797, Part III, to figure the ordinary income part of a gain from the sale, exchange, or involuntary conversion of section 1252 property and section 1255 property.

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