Susan Voss, CPA, TD&T’s Agriculture Industry Leader, provides the next installment in her series on helping farm families understand and respond to changes in agribusiness.
Here in the Midwest, we encounter events that change our operation’s plan on a fairly regular basis. The wildfires that recently occurred in Kansas are a good example of what can happen quickly to change the face of farming for a few seasons to come. We’re going to visit some tax law that helps to soften the blow of the complete or partial destruction of property in a sudden, unexpected or unusual way. I’d like to thank Roger McEowen, Clifton Larson Allen for providing some nice insight to this subject. Roger has been a featured speaker at the Ag Conference TD&T hosts late in the summer each year. Check out tdtpc.com for the latest information about the 2017 Ag Conference!
Disasters in the Ag Environment Are Common
Weather-related events can seriously damage or ruin farm and ranch property. The massive wildfires in parts of Kansas and the horrific pictures have illustrated the devastation that the affected farmers and ranchers have suffered. We have all seen pictures of dead livestock, burned-up fences and pastures, and the buildings and homes destroyed by natural events. While people experience large financial losses in these events, tax law provides some provisions that can at least partially soften the impact.
When an identifiable event of a sudden, unexpected or unusual nature results in the complete or partial destruction of property, the law defines that as a casualty loss. You can deduct casualty losses regardless of whether you use the property in a trade or business, hold it for the production of income or hold it for personal purposes. The rules differ slightly on how to calculate the loss for tax purposes.
To value the amount of the deduction for casualty losses, you take the lesser of the following:
- The difference between the fair market value before the casualty or theft and the fair market value afterwards
- The amount of the adjusted income tax basis for purposes of determining loss
The amount of the deduction can never exceed the basis in the item that suffers the casualty. This means that the amount of the loss equals the economic loss suffered, limited by the basis (and any insurance recovery). In farming, crops in the field and raised livestock have zero basis to cash basis farmers, meaning no casualty loss. You’ve deducted all the current input costs associated with those crops and raising those livestock. Lost revenue is not a deduction.
Here’s a simple example:
Assume a rancher has five Hereford cows and one Hereford bull in a pasture. A lightning strike ignites a wildfire which spreads rapidly by high winds. The cows and bull are caught in the fire and are killed. The rancher raised the cows so they have a basis of $0.00 and a fair market value of $4,500. The bull, which the rancher purchased for $5,000, had a fair market value of $6,000 at the time of death. The amount of the casualty loss is the difference in the fair market value before and after the loss: $10,500 ($10,500 – $0.00). However, because the cows had a basis of $0.00, the basis for all of the animals totals only $5,000 – the basis of the bull. Because the deductible loss can never exceed the basis, the amount of the deduction is limited to $5,000.
In addition, any insurance recovery will further reduce the casualty loss. For example, if the rancher collected $4,500 of insurance on the dead cattle, that would limit the deductible loss to $500. The rancher needs to take the deduction in the year in which he incurred the loss. It is claimed on Section B of Form 4684 and on Form 4797.
In the above example, if the rancher’s deduction due to casualty loss exceeds his income for the year in which he claims the loss, he may have a net operating loss (NOL) for that year. He would be entitled to a two-year carryback and a 20-year carryforward. The portion of the NOL arising from the casualty loss has a three-year carryback period. I.R.C. §172(b)(1)(E).
Let’s expand the example a bit. Suppose that the wildfire destroyed the rancher’s pasture as well, but he had other livestock that survived. Without a usable pasture, the rancher had to sell the livestock. The rancher may now claim an involuntary conversion or exchange.
Suppose a rancher sells more livestock (other than poultry) held for draft, dairy or breeding purposes than the number of livestock he would normally sell during the same time period. The rancher can treat the sale as a nontaxable involuntary conversion or exchange, if the sale occurs because of drought, flood or other weather-related condition. He must replace the livestock sold or exchanged with livestock similar or related in service or use within two years after the year in which he received proceeds. (For example, he must replace dairy cows with dairy cows.) He has to hold the livestock for the same purpose that the animals given up had provided. Therefore, he can not replace dairy cows with breeding animals.
Options for Reinvestment
The sale of the replacement animals triggers the tax on the sale. If the rancher can’t reinvest the proceeds in property similar or related in use, he can reinvest the proceeds in other property used for farming purposes (except real estate). If it make no sense to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, he can invest in property that is not like-kind or real estate used for farming purposes. I.R.C. §1033(f).
If the rancher replaces livestock because of the weather-related condition, he will have to hold the new livestock for the same purpose as the previous animals served. Treas. Reg. § 1.1033(e)-1(d).
In areas the federal government designates as eligible for assistance, the two-year replacement period increases to four years (i.e., by the President or any agency or department of the federal government). I.R.C. §1033(e)(2)(A). Presumably, any livestock sales that occur before the designation of an area as eligible for federal assistance would also qualify for the extended replacement period if the drought, flood, or other weather-related conditions that caused the sale also caused the area to be so designated. The Treasury Secretary has the authority to extend, on a regional basis, the period for replacement if the weather-related conditions continue for more than three years. I.R.C. §1033(e)(2)(B).
Electing to Defer the Gain
You can elect to defer the gain by attaching a statement to your tax return providing evidence of the weather-related condition that caused the early sale. The statement needs to include the computation of the gain realized, the number and kind of livestock sold and the number and kind of livestock that would have been sold under normal business practices.
- You can make the election at any time within the normal statute of limitations for the period in which you recognize the gain. It must occur before the expiration of the period in which the converted property must be replaced.
- If you file the election but do not acquire eligible replacement property within the applicable replacement period (usually four years), you will have to file an amended return for the year in which you originally realized the gain.
- If you replace the animals, you should include information with the return that shows the purchase date of the replacement livestock, the cost of the replacement livestock and the number and kind of the replacement livestock.
- You must make the election in the return for the first tax year in which you realize any part of the gain from the sale.
- Obviously, you need to maintain sufficient records to support the nonrecognition of gain.
If a partnership owns livestock and sells them, the election is the responsibility of the partnership. See Rosefsky v. Comr., 599 F.2d 515 (2d Cir. 1979).
How the Two Rules Interact
Continuing the above example, assume that the rancher received more than $5,000 in insurance proceeds, or the net book value of the animals. Suppose the rancher received $6,000 from insurance, he would owe tax on the $1,000 that exceeds the tax basis of the dead animals. The rancher can defer that potential taxable gain if he makes a valid election to defer the gain, and replaces the livestock within the applicable timeframe. In that instance, he can defer the $1,000 casualty gain until he sells the replacement animals. He might save more in taxes if he instead reports the gain on the animals and claims ordinary depreciation on the replacement animals.
The One-Year Deferral Rule
If drought or other weather-related conditions force farm or ranch taxpayers to dispose of more livestock than they would have sold in a normal business situation, they may choose to defer reporting the gain associated with the excess until the following taxable year. I.R.C. §451(e). The taxpayer’s principal business must be farming in order to take advantage of this provision.
What if the livestock owner doesn’t know which election would be his best choice at tax time? The IRS permits a “protective” election under I.R.C. §1033 for that tax year. This allows revoking an involuntary election and then filing amended returns for both tax years affected. The IRS code offers a number of options for taxpayers who make an election but fail to acquire replacement livestock in the required four-year period. TD&T professionals would be happy to consult with you if you face these kinds of situations.
Other Forms of Incorporation
Some farming operations organized in forms other than as a C corporation have specific limitations. When they receive “applicable subsidies,” the law limits overall farming losses to the greater of $300,000 (or $150,000 for a farmer filing as married filing separately) or the aggregate net farm income over the previous five-year period. Figuring this limitation disregards farming losses from casualty losses or losses by reason of disease or drought. I.R.C. §461(j).
You may find farm income averaging a useful tool in a tax year in which you experienced a substantial casualty. You may also find significant tax planning opportunities by using a combination of income averaging, casualty loss rules, the tax treatment of livestock sold on account of weather-related conditions and loss carryback rules.
We Can Help
When casualty loss occurs, it can hit a farmer or rancher hard. The tax code offers a number of options to help minimize the impact. As always, TD&T tax professionals can help you navigate through these many potentially complicated choices.