Monday, February 12, 2018
Although the loss of livestock due to disease does not occur that frequently, when it occurs the loss can be large. Fortunately, the tax Code provides a special rule for the handling of the loss. The rule is similar to the rules that apply when excess livestock are sold on account of weather-related conditions.
Today’s post takes a look at the tax rule for handling sale of livestock on account of disease.
Treatment as an Involuntary Conversion
Gain deferral. Similar to the drought sale rules, livestock that are sold or exchanged because of disease may not lead to taxable gain if the proceeds of the transaction are reinvested in replacement animals that are similar or related in service or use (in other words, dairy cows for dairy cows, for example) within two years of the close of the tax year in which the diseased animals were sold or exchanged. I.R.C. §1033(d). More specifically, the replacement period ends two years after the close of the tax year in which the involuntary conversion occurs and any part of the gain is realized. I.R.C. §1033(a)(2)(B)(i). In that event, the gain on the animals disposed of is not subject to tax. Instead, the gain is deferred until the replacement animals are sold or exchanged in a taxable transaction. The taxpayer's basis in the new animals must be reduced by the unrecognized gain on the old animals that were either destroyed, sold or exchanged. Treas. Reg. §1.1033(b)-1.
Note: Involuntary conversion treatment is available for losses due to death of livestock from disease. It doesn’t matter whether death results from normal death loss or a disease causes massive death loss. Rev. Rul. 61-216, 1961-2 C.B. 134. In addition, involuntary conversion treatment applies to livestock that are sold or exchanged because they have been exposed to disease. Treas. Reg. §1.1033(d)-1.
When is gain recognized? Gain is realized to the extent money or dissimilar property is received in excess of the tax basis of the livestock. For farmers on the cash method of accounting, raised livestock has no tax basis. Therefore, gain is realized upon the receipt of any compensation for the animals. See, e.g., Decoite v. Comr., T.C. Memo. 1992-665. Thus, if there is gain recognition on the transaction, it occurs to the extent the net proceeds from the involuntary conversion are not invested in qualified replacement property. I.R.C. §1033(a)(2)(A). The gain (or loss) is reported on Form 4797. A statement must be attached to the return for the year in which gain is realized (e.g., the year in which insurance proceeds are received). Treas. Reg. 1.1033(a)-2(c)(2). The statement should include the date of the involuntary conversion as well as information concerning the insurance (or other reimbursement) received. If the replacement livestock are received before the tax return is filed, the attached statement must include a description of the replacement livestock, the date of acquisition, and their cost. If the animals will be replaced in a year after the year in which the gain is realized, the attached statement should evidence the taxpayer’s intent to replace the property within the two-year period.
Disease is not a casualty. Under the casualty loss rules, a deduction can be taken for the complete or partial destruction of property resulting from an identifiable event of a sudden, unexpected or unusual nature. Rev. Rul. 72-592, 1972-2 C.B. 101. Livestock losses because of disease generally would not be eligible for casualty loss treatment because the loss is progressive rather than sudden. Thus, casualty loss treatment under I.R.C. §165(c)(3) does not apply. However, this provision doesn’t apply to losses due to livestock disease. I.R.C. §1033(d). Stated another way, the “suddenness” test doesn’t have to be satisfied to have involuntary conversion treatment apply. See Rev. Rul. 59-102, 1959-1 C.B. 200.
What is a “disease”? While a livestock disease need not be sudden in nature for the sale or exchange of the affected livestock to be treated under the involuntary conversion rules, a genetic defect is not a disease. Rev. Rul. 59-174, 1959-1 C.B. 203. However, livestock that consume contaminated feed and are lost as a result can be treated under the involuntary conversion rules. Rev. Rul. 54-395, 1954-2 C.B. 143.
What qualifies as “replacement animals”? I.R.C. §1033(d) says that if “livestock” are destroyed, sold or exchanged on account of disease then involuntary conversion treatment can apply. But, what is the definition of “livestock” for involuntary conversion purposes? The definition of “livestock” under I.R.C. §1231 applies for involuntary conversion treatment. Treas. Reg. §1.1231-2(a)(3). Under that regulation, “livestock” includes “cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals.” It does not include “poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs, reptiles, etc.” The IRS has ruled that honeybees destroyed due to nearby pesticide use qualified for involuntary conversion treatment. Rev. Rul. 75-381, 1975-2 C.B. 25.
Environmental contamination. If it is not feasible to reinvest the proceeds from involuntarily converted livestock into other like-kind livestock due to soil or other environmental contamination, the proceeds can be invested into non-like-kind farm property or real estate used for farming purposes. I.R.C. §1033(f). A communicable disease may not be considered to be an environmental contaminant. Miller v. United States, 615 F. Supp. 160 (E.D. Ky. 1985).
While the destruction, sale or exchange of livestock on account of disease is uncommon, it does occur. When it does, the financial impact on the farming or ranching business can be substantial. Fortunately, there is a tax rule that helps soften the blow.