Tax Issues on Repossession of Farmland

Overview

Financial distress in the farm sector continues to be a real problem.  Low prices in recent years has added to the problem, as have increased debt levels as a result of financed asset purchases during the economic upswing in the ag economy in earlier years.  As an example, the level of working capital in the farm sector has fallen sharply since 2012.  Working capital for the farm sector as a whole (current assets less current liabilities) is at its lowest level in 10 years, presently at 36 percent of its 2012 peak.   In the past year alone, working capital dropped by 18 percent.  It has also declined precipitously as a percentage of gross revenue.  This means that many farmers have a diminished ability to reinvest in their farming operations.  It also means that there is an increased likelihood that a farmer may experience the repossession of farm personal property and real estate.  When that happens, the sellers of the assets that repossess have tax consequences to worry about.

Sometimes a Chapter 12 bankruptcy might be filed – and those filings are up in parts of the Midwest and the Great Plains.  Other times, farmland might be repossessed. 

Tax issues upon repossession of farmland – that’s the topic of today’s post.

Repossession of Farmland

Special exception.  A special exception exists under I.R.C. § 1038 that is very favorable to sellers repossessing land under an installment sale – the seller need not recognize gain or loss upon the repossession in either full or partial satisfaction of the debt.  It doesn’t matter what method of accounting the seller used in reporting gain or loss from the sale or whether at the time of reacquisition the property has increased or decreased in value since the time of the original sale.   However, the rules do not apply if the disposition constitutes a tax-free exchange of the property, and a special problem can be created if related parties are involved.  See I.R.C. §453B(f)(2).  In addition, for the special rules to apply, the debt must be secured by the real property.

When real property is repossessed, whether the repossession is voluntary or involuntary, the amount of gain recognized is the lesser of - (1) the amount of cash and the fair market value of other property received before the reacquisition (but only to the extent such money and other property exceeds the amount of gain reported before the reacquisition); or (2) the amount of gain realized on the original sale (adjusted sales price less adjusted income tax basis) in excess of the gain previously recognized before the reacquisition and the money or other property transferred by the seller in connection with the reacquisition.

Handling interest.  Amounts of interest received, stated or unstated, are excluded from the computation of gain.  Because the provision is applicable only when the seller reacquires the property to satisfy the purchaser's debt, it is generally inapplicable where the seller repurchases the property by paying the buyer an extra sum in addition to cancelling the debt.  However, if the parties are related, the seller (according to the statute) must report interest debt that is canceled as ordinary income.  I.R.C. §453B(f)(2).  But, a question exists as to whether that provision applies in financial distress situations.

The rules generally are applicable, however, if the seller reacquires the property when the purchaser has defaulted or when default is imminent even if the seller pays additional amounts. 

Debt secured by the real property.  The provisions on repossession of real property do not apply except where the indebtedness was secured by the real property.  Therefore, reconveyance of property by the obligor under a private annuity to the annuitant would appear not to come within the rules.

Character of gain.  The character of the gain from reacquisition is determined by the character of the gain from the original sale.  For an original sale reported on the installment method, the character of the reacquisition gain is determined as though there had been a disposition of the installment obligation.  If the sale was reported on the deferred payment method, and there was voluntary repossession of the property, the seller reports the gain as ordinary income.  If the debts satisfied were securities issued by a corporation, government or political subdivision, the gain would be capital gain. 

Basis issues.  Once the seller has reacquired the property, it is important to determine the seller's basis in the reacquired property.  The adjusted income tax basis for the property in the hands of the reacquiring seller is the sum of three amounts - (1) the adjusted income tax basis to the seller of the indebtedness, determined as of the date of reacquisition; (2) the taxable gain resulting from reacquisition; and (3) the money and other property (at fair market value) paid by the seller as reacquisition costs. 

The holding period of the reacquired property, for purposes of subsequent disposition, includes the holding period during which the seller held the property before the original sale plus the period after reacquisition.  However, the holding period does not include the time between the original sale and the date of reacquisition. 

Is the personal residence involved?  The provisions on reacquisition of property generally apply to residences or the residence part of the transaction.  However, the repossession rules do not apply if - (1) an election is in effect for an exclusion on the residence (I.R.C. §121) and; (2) the property is resold within one year after the date of reacquisition. See, e.g., Debough v. Comm’r, 142 T.C. No. 297 (2014), aff’d, 799 F.3d 1210 (8th Cir. 2015). If those conditions are met, the resale is essentially disregarded and the resale is considered to constitute a sale of the property as of the original sale. In general, the resale is treated as having occurred on the date of the original sale.  An adjustment is made to the sales price of the old residence and the basis of the new residence.  If not resold within one year, gain is recognized under the rules for repossession of real property.  An exclusion election is considered to be in effect if an election has been made and not revoked as of the last day for making such an election.  The exclusion can, therefore, be made after reacquisition.  An election can be made at any time within three years after the due date of the return.

No bad debt deduction is permitted for a worthless or a partially worthless debt secured by a reacquired personal residence, and the income tax basis of any debt not discharged by repossession is zero.  Losses are not deductible on sale or repossession of a personal residence.  When gain is not deferred or excluded, the repossession of a personal residence is treated under the general rule as a repossession of real property.  Adjustment is made to the income tax basis of the reacquired residence.

Special situations.  In 1969, the IRS ruled that the special provisions on income tax treatment of reacquisition of property did not apply to reacquisition by the estate of a deceased taxpayer. Rev. Rul. 69-83, 1969-1 C.B. 202.  A decedent's estate was not permitted to succeed to the income treatment that would have been accorded a reacquisition by the decedent.  However, the Installment Sales Revision Act of 1980 changed that result.  The provision is effective for “acquisitions of real property by the taxpayer” after October 19, 1980.  Presumably, that means acquisitions by the estate or beneficiary.  Under the 1980 amendments, the estate or beneficiary of a deceased seller is entitled to the same nonrecognition treatment upon the acquisition of real property in partial or full satisfaction of secured purchase money debt as the deceased seller would have been.  The income tax basis of the property acquired is the same as if the original seller had reacquired the property except that the basis is increased by the amount of the deduction for federal estate tax which would have been allowable had the repossession been taxable. 

The IRS ruled in 1986 that the nonrecognition provision on repossessions of land does not apply to a former shareholder of a corporation who receives an installment obligation from the corporation in a liquidation when that shareholder, upon default by the buyer, subsequently receives the real property used to secure the obligation. Rev. Rul. 86-120, 1986-2 C.B. 145.

Conclusion

Tax planning is important for farmers that are in financial distress and for creditors of those farmers.  As usual, having good tax counsel at the ready is critical.  Tax issues can become complex quickly.