Monday, March 15, 2021
Last week, in Part One, I discussed the basic structure and scope of I.R.C. §1231. In today’s post I continue with the definition of “livestock for purposes of I.R.C. §1231, the “holding period” requirement and the procedure for netting gains and losses, as well as the proper classification of unharvested crops that are sold with land.
The unique tax treatment of “Section 1231” assets for farmers and ranchers, Part Two of what has now become a Three-Part series – it’s the topic of today’s post.
Benefit of Section 1231
As mentioned in Part One, upon the sale or exchange of Section 1231 property, the result is either capital gain or ordinary loss. Net gains from the sale of Section 1231 assets are long-term capital gains. As such, they are taxed at favorable rates. Presently, long-term capital gains are taxed at the rate of zero percent, 15 percent, or 20 percent, depending on a combination of the taxpayer’s taxable income and marital status. For a husband and wife filing jointly, the 20 percent rate kicks-in at an income above $501,600. The capital gain rate for a married couple filing jointly is zero up to an income level of $80,800.
If the losses on Section 1231 transactions exceed the gains, the net loss is treated as an ordinary loss. That’s also a favorable outcome for the taxpayer. But, it’s important to remember that I.R.C. § 1231 does not apply to depreciation that must be recaptured as ordinary income under either I.R.C. § 1245 (depreciable personal property and certain real property) or I.R.C. §1250 (depreciable real property that is not I.R.C. §1245 property).
Definition of “Livestock”
“Livestock” is defined broadly for Section 1231 purposes. The term includes cattle, hogs, horses, mules, donkeys, sheep, goats, fur-bearing animals and other mammals. Treas. Reg. §1.1231-2(a)(3). The term can also include trophy deer that are raised as part of a taxpayer’s trade or business of farming. See TAM 9615001 (Oct. 17, 1995). But “livestock” for Section 1231 purposes does not include poultry, chickens, turkeys, pigeons, geese, other birds, fish, frogs or reptiles. Treas. Reg. §1.1231-2(a)(3). In general, the term includes any mammal held for breeding or sporting purposes. including some furbearing animals. For example, Chinchilla count if the taxpayer holds them for breeding purposes. Greer v. Comr., 17 T.C. 965 (1951), acq., 1953-1 C.B. 4. Mink and fox also count Rev. Rul. 57-88, 1957-1 C.B. 88. Likewise, culled mink pelts also can be treated as a Section 1231 asset in the hands of a taxpayer engaged in the trade or business of raising mink for the purpose of selling mink pelts. United States v. Cook, 270 F.2d 725 (8th Cir. 1959). But, bees (and probably, other insects) are not “livestock” for Section 1231 purposes. Sykes v. Comr., 57 T.C. 618 (1972).
To receive Section 1231 treatment, qualified livestock that are held for a qualified purpose (draft, dairy, breeding or sporting purposes) a taxpayer must hold the livestock for a required amount of time. I.R.C. §1231(b)(3). For cattle and horses, the holding period is at least 24 months. I.R.C. §1231(b)(3)(A). For all other livestock, the holding period is at least 12 months. I.R.C. §1231(b)(3)(B).
Measuring – general rule. A taxpayer determines whether the holding period has been satisfied by not counting the day on which an asset was acquired and including the day on which the asset is sold. Rev. Rul. 66-7, 1966-1 C.B. 188; Caspe v. United States, 694 F.2d 1116 (8th Cir. 1982).
Measuring – sale by an estate. Property that is included in a decedent’s estate at death and receives a basis equal to the fair market value of the property at death under I.R.C. §1014 is treated at having been held for more than one year. I.R.C. §1223(9). It doesn’t matter how long the taxpayer actually held the property before death. Id. Likewise, for property that a decedent holds until the date of death, if it is disposed of within 18 months after the decedent’s death, it is deemed to have been held more than 18 months. IRS Notice 97-59, 1997-2 C.B. 309. But, this rule doesn’t apply to livestock – the special holding periods for livestock contained in I.R.C. §1231(b)(3)(A)-(B) continue to apply. Rev. Rul. 75-361, 1975-2 C.B. 344. Thus, the decedent must have held the livestock for the applicable holding period before death for the heir to receive long-term capital gain treatment upon sale by the estate.
The “Netting” Process
For Section 1231 assets, net gains from them are long-term capital gains. If losses are greater than gains, the net loss is treated as an ordinary loss. I.R.C. §1231(a)(2). Stated another way, if net Section 1231 losses exceed net Section 1231 gains, the gains and losses are not treated as “gains and losses from sales or exchanges of capital assets.” Id. The instructions to IRS Form 4797 set forth how to report Section 1231 transactions. But, in a nutshell, long-term capital gains and losses (including Section 1231 gains and losses) are separated by the tax rates that apply to them. The assets are separated by type (e.g., capital loss carryovers; collectibles; unrecaptured I.R.C. §1250 gain; gain taxed at 10 percent, etc.). Then, short-term capital losses (including short-term capital loss carryovers) are applied first to reduce short-term capital gains in a particular order (tied to the applicable tax rate). After that, any net loss from a particular tax rate group reduces gain from gains that are taxed at different rates in a specified order. This is all set forth in the instructions to Form 4797 in good detail.
What About Unharvested Crops Sold With Land?
For land that is sold with an unharvested crop, if both the land and the growing crops are used in the seller’s trade or business of farming and are sold (or exchanged or compulsorily or involuntarily converted) to the same buyer in a single transaction, the land and crops are considered to be “property used in the trade or business.” I.R.C. §1231(b)(4). If the seller held the land for more than a year before the sale, Section 1231 treatment is available. Treas. Reg. §1.1231-1(c)(5).
But, a catch is present if the taxpayer is on the cash method. In this situation, when computing taxable income, the seller cannot claim any deductions for the unharvested crop attributable to the crop’s production either for the tax year of sale or not. The seller must capitalize the costs of raising the crop. I.R.C. §268.
Another point is that Section 1231 treatment is not available for an unharvested crop if the seller retains any right or option, either directly or indirectly, to reacquire the land that the crop is growing on. Treas. Reg. §1.1231-1(f); Priv. Ltr. Rul. 8504014 (Oct. 22, 1984). For this purpose, a right that is incident to a mortgage (or other security interest) is not considered to be a “right or option.” Treas. Reg. §1.1231-1(f).
Note: A leasehold or an estate for a term of years is not “land” for purposes of Section 1231. Id. Thus, when a crop is raised on land where the taxpayer (as landlord) sells the lease and the unharvested crop in one transaction, the sale results in ordinary income. Bidart Brothers v. United States, 262 F.2d 607 (9th Cir. 1959).
The sale of raised crops or livestock in the estate of a decedent that was an active farmer generally results in ordinary income recognition. Sale of land on which crops constituting property are growing, by an estate, results in capital gain treatment for the income attributable to the crop. I.R.C. §§268; 1231(b)(4). If the crops are harvested during the process of liquidating the farming business and selling the land, it might be possible to characterize the sale of the crops as part of the liquidation and achieve capital gain treatment.
In Part Three next time, I will continue the Section 1231 discussion as applied to the sale of water rights, livestock self-rent situations, and timber sales. Stay tuned.