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IOWA'S SUPER-LONG TERM CAPITAL GAINS DEDUCTION: IF YOU QUIT, DON'T WAIT TOO LONG TO RETIRE

January 31, 2006

Iowa has an unusual tax exemption for certain business capital gains. It applies if you meet two conditions:

- You "held" the property for ten years, and

- You "materially participated" in the business owning the property for 10 years.

If you miss either requirement, you lose the exemption.

For the most part, "material participation" means the same thing as it does for the federal "passivie activity" rules. This usually means 500 hours of work each year (a more complete summary is in the extended entry below).

POST-RETIREMENT PARTICIPATION

When you retire, your participation lingers under the federal rules. For most businesses, you are considered to materially participate if you have done so for five of the past ten years. This means your participation "continues" for five years after retirement. For professional service businesses, participation continues until death, even after retirement (no "of counsel" jokes allowed).

Iowa follows these rules for non-farmers. That means you have five years to sell your business property after retirement to qualify for the Iowa exclusion.

RETIRE A FARMER, DIE A FARMER

Farmers, though, get a special Iowa break. They qualify for the deduction for any property in which they materially participated for five out of eight years before "retiring" -- whatever that means. That usually works out well for farmers, because they can retire, cash rent their land, and still qualify for the deduction ten years later when they finally pack up and move to Sun City.

The key question, though, is when "retirement" occurs. A policy letter issued this month shows that the Department of Revenue doesn't necessarily equate "quitting" with "retiring." The letter has a spare fact summary:

The situation posed in your letter involves 100 acres of farmland which has been jointly owned by a husband and wife since 1974. The husband materially participated in the farming operation, and the wife actively participated with the husband in the farming operation. The husband also owned a dairy operation and used the crops from the 100 acres of farmland to help support the dairy operation. The dairy operation was liquidated in March 1993, and the 100 acres of farmland was been cash rented since 1993. The husband and wife retired and began receiving social security benefits in 1997.

The husband and wife are now planning to sell the 100 acres of farmland, and are requesting an opinion on whether the capital gain from the sale of the farmland would qualify for the capital gain deduction.

The letter ruled that the couple failed to qualify because they hadn't materially participated "the farmland" in five of the eight years before "retirement." They said retirement didn't occur until June 1997 when the couple started receiving social security benefits, and that 1992 was the last year of "material participation." since they had failed to participate in the last four-plus years before "retirement," the letter holds, they failed the "five of eight" year test.

PROBLEMS WITH THE RULING

The first problem that leaps out is technical: the statement that the couple didn't participate in the activity in 1993, the year they liquidated the herd. I believe this is exactly the type of situation that the "facts and circumstances" test of the material participation rules is meant to cover - years in which the taxpayers still were in the business, but not for long enough in the year to reach 500 hours of work. The letter anticipates it by saying the taxpayer wouldn't have qualified anyway, because the July 1997 start of Social Security benefits was more than four years after the March 1993 liquidation.

The second problem is key to the ruling: the Department considers the dairy business to be a separate business from the remaining business that apparently continued until 1997. The Department doesn't say why this is so. Did the farmers report dairy income as a separate Schedule F activity?

Finally, The regulation covering "material participation" doesn't define "retirement" anywhere. I suspect that the couple considered themselves "retired" from the dairy operation when the truck drove off with the last cow. It's unfortunate that the meaning of the key term "retirement" is left to the chance whims of the Department.

Cite: Policy Letter of January 6, 2006.

MATERIAL PARTICIPATION BASICS

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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