Wednesday, February 26, 2020
The economic loss of livestock for an agricultural producer is difficult. In a prior post I discussed the USDA’s livestock indemnity program. https://lawprofessors.typepad.com/agriculturallaw/2017/03/livestock-indemnity-payments-what-they-are-and-tax-reporting-options.html. That program can provide some financial relief when livestock die because of adverse weather conditions or attacks by animals that the Federal Government has reintroduced into the wild. But a significant concern is the tax treatment of livestock death losses. Can a loss deduction be claimed? If so, what is the character of the loss? How is the loss reported on the tax return?
The tax rules surrounding death of livestock – that’s the focus of today’s post.
Required Holding Period
The tax consequences of dead livestock are tied to how long the taxpayer “held” the livestock. The tax consequences upon death of livestock that are held for draft, dairy, breeding or sporting purposes differ depending on whether the taxpayer held the animals for 12 months or more (24 months or more for cattle and horses) that if they were not held for that requisite time period. If they have been held for the required holding period, they are “I.R.C. §1231 property.” Why is being I.R.C. §1231 property beneficial? It allows a taxpayer to receive tax-favored treatment for I.R.C. §1231 property gains that exceed I.R.C. §1231 property losses. Thus, if an I.R.C. §1231 asset can be sold for a value greater than its original cost basis, it can be taxed at a favorable capital gains rate. But, if a loss results, it is a fully deductible ordinary loss rather than a capital loss capped at $3,000 against ordinary income with any excess carried over to the following year.
I.R.C. §1231 property includes depreciable property and real property (e.g. buildings and equipment) used in a trade or business and generally held for more than one year. As noted, some types of livestock, coal, timber and domestic iron ore are also included in the definition of I.R.C. §1231 property. But, the category of I.R.C. §1231 property does not include inventory; property held for sale in the ordinary course of business; artistic creations held by their creator; or, government publications.
Gains and losses under I.R.C. §1231 due to casualty or theft are excluded from the netting process unless the gains exceed the losses. In that situation, both the gain and loss are calculated with any other I.R.C. §1231 gains and losses. If casualty losses exceed gains, the excess is treated as an ordinary loss. This all means that gain or loss that is triggered upon death may be included in the I.R.C. §1231 netting process.
If draft, dairy, breeding or sporting purpose livestock has been held for less than 12 months (24 months for cattle and horses) as of the time of the animal’s death, the gain or loss is not an I.R.C. §1231 gain or loss. It is reported on Part II of Form 4797. In this instance, it makes no difference whether the animal’s death was caused by casualty or disease.
Death Due to Casualty
Losses resulting from casualty-caused deaths are netted with the taxpayer’s other business casualty gains and losses to determine whether they will be included in the I.R.C. §1231 netting process. If the casualty gains exceed the casualty losses, the net gain is included with other I.R.C. §1231 gains and is netted against I.R.C. §1231 losses for the year. If the casualty losses exceed the casualty gains, the net loss is not included in the I.R.C. §1231 netting process. Rather, it’s allowed as an ordinary deduction for income tax purposes but not for self-employment tax purposes.
(Facts): In the spring of 2019, a “bomb cyclone” completely destroyed Slim’s barn and killed the 25 dairy cows that were in the barn. At the time of the weather event, assume that Slim’s income tax basis in the barn was $50,000 and its fair market value was $100,000. Slim received a $90,000 insurance payment for the destroyed barn. Thus, Slim has $40,000 gain as a result. As for the cows in the barn at the time of the casualty, assume that they were worth $20,000 immediately before the casualty and that Slim’s basis in the cows was $8,000. He didn’t receive any insurance proceeds attributable to the cows. Thus, Slim sustained an $8,000 loss on the cows.
(Result): Slim will report the loss of his barn and cows and the insurance payment for the barn on Form 4684. Neither his barn nor the cows will be subject to depreciation recapture because Slim claimed straight-line depreciation on the barn and there is no gain on the cows. Slim will report the net casualty gain on Form 4797, Part I, line 3. There it is netted with any other I.R.C. §1231 gains and losses that Slim incurred during the tax year.
Tax planning opportunities. If Slim has a net I.R.C. §1231 gain for the tax year, his loss on the cows will reduce the gain that would be taxed as capital gain. If he has a net I.R.C. §1231 loss for the year, his loss on the cows will increase the net I.R.C. §1231 loss, which is fully deductible as an ordinary loss. Under another rule, gain that is realized from casualty to business property can be rolled into replacement property. I.R.C. §1033. The replacement property must be purchased within two years of the end of the tax year of the involuntary conversion. I.R.C. §1033(a)(2)(B)(i). Thus, if Slim replaces the barn, he can roll the gain into the new barn and the loss from the cows would not be netted against the gain from the barn. The loss would avoid the I.R.C. §1231 netting process and be deducted against ordinary income. If Slim had a net loss on the barn (perhaps because the insurance pay-out was less), he would report the net loss from the casualty on Form 4684 but would not net it with his I.R.C. §1231 gains and losses for the tax year. Rather, it is reported on Part II of Form 4797 (or directly on Form 1040 if Form 4797 is not otherwise needed) where it will reduce ordinary income not subject to self-employment tax.
If Slim had triggered gain on the loss of the livestock, he could have elected to postpone gain recognition by under the involuntary conversion rule by investing the proceeds in livestock that are similar in service or use to the livestock that died. I.R.C. §1033(a). Normally, the livestock must be purchased by the end of the second tax year after the year the livestock died. If Slim makes the election to postpone the gain, but then does not purchase replacement livestock within the required timeframe, he will have to amend his return for the year of death to report the gain. The definition of “livestock” for purposes of I.R.C. §1231 applies for purposes of the involuntary conversion rule. Treas. Reg. §1.1231-2(a)(2).
If the cows had died as the result of a presidentially declared disaster, Slim could elect to deduct the loss for the year preceding the year of the loss. I.R.C. §165(i). Slim would accomplish this by amending the prior year’s return. Claiming the loss in the prior year could reduce the net I.R.C. §1231 gain for the current year which is taxed as capital gain. That could allow the loss to be deducted from ordinary income if Slim didn’t have any casualty or theft gains on that prior year’s return.
While the above example indicated that depreciation recapture was not triggered, what if a casualty does trigger depreciation recapture? If that happens, the recaptured depreciation is reported as ordinary income on Part III of Form 4797. It does not become part of the I.R.C. §1231 netting process.
Death Due to Disease
Disease is not a casualty. To be treated for tax purposes as a casualty, the loss must be “sudden, unexpected and unusual.” See, e.g., Rev. Rul. 72-592, 1972-2 C.B. 101. Disease is too gradual in nature to be treated as a casualty. Instead, it is an involuntary conversion and if the diseased livestock qualify as I.R.C. §1231 property, the gain or loss from the death is netted with other I.R.C. §1231 transactions for the tax year. The tax reporting of the livestock death would be in Part I of Form 4797 (unless depreciation recapture is present).
Livestock deaths can be economically devastating for a agricultural operation. However, understanding the associated tax rules and the related planning opportunities can help soften the blow.