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FARMERS AND ULTRA LONG-TERM CAPITAL GAINS

May 25, 2004

Iowa has a tax reward for some of its most resilient taxpayers. These hardy souls are excused from Iowa income tax on gains from real property held for ten years and used in a trade or business in which they "materially participated" for ten years. This fits many farmers.

The Iowa Department of Revenue this week issued a policy letter on how this affects the spouse of a deceased farmer. It turns out that eligibility for this exclusion is very fact-specific, and some of the results seem almost whimsical.

The letter addressed how the title of farmland affects eligibility for the capital gain deduction when the farmer met the material participation and holding-period requirements before death and the property is sold five years later by the surviving spouse. A spouse is considered to materially participate for all years in which the other spouse materially participated, so only holding periods are at issue in the examples.

TENANCY-IN-COMMON. The surviving spouse is treated as acquiring the decedant's tenancy interest at death. The survivor is treated as meeting the holding period requirement only for "her" half of the tenancy-in-common that she held before her husbands death. Her sale of the farmland previously held as tenant-in-common is therefore only eligible for the capital gain deduction for "her" share of the tenancy in common held before the husband's death.

JOINT TENANCY. This is a different matter. The Department says:

   "If the ownership was joint tenancy, both 
   the husband and wife are deemed to own 
   100% of the farmland.  In this case, the 
   surviving spouse would have been entitled 
   to take the capital gain deduction on the 
   entire farmland, since she would have met 
   the 10 year ownership requirement.." 

So: joint tenancy, good; tenancy-in-common, bad.

BYPASS TRUST. What if the husband's interest in the land goes to a "by-pass trust" under the terms of the will? Bad:

   "The Department considers any transfer of 
   real property as an event which starts the
   ten year holding period and ten year 
   material participation period for the new 
   owner.  Therefore, if the farmland was sold
   five years after the husband’s death, any 
   capital gain reported by the trust, even if 
   the proceeds were distributed to the 
   surviving spouse, would not qualify for the 
   capital gain deduction since the ten year 
   ownership period and ten year material 
   participation period was not met by the 
   trust." 

LIKE-KIND EXCHANGE DOESN'T HELP. The policy letter goes on to say that if the spouse did a like-kind exchange of other long-held property to the trust to acquire the spouse's interest, it still wouldn't qualify. While for federal tax purposes the holding period of land given up in the exchange would "tack" to that of the land acquired from the trust, it would not do so for the Iowa capital gain deduction. The ten-year holding period for the deduction would instead start at the exchange date.

LESSONS:

Iowa farmers should take this policy letter into account in their estate planning. While the basis step-up at death to fair market value often makes capital gain go away, it doesn't always. A farmer whose fields lie in the path of suburban growth can see a lot of appreciation in five years.

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