Tax treatment of equipment trade-ins got a tune-up in 2017’s tax reform legislation. Experts say provisions restricting like-kind exchanges for machinery are offset by more generous rules on depreciation, resulting in little change to federal tax returns.
The complication: many states didn’t follow suit, especially on like-kind exchanges, which are also known as 1031 exchanges and allow taxpayers to trade equivalent properties without a taxable event taking place.
“In my state, Minnesota, if the legislature does not fix the 1031 issue we may have farmers owing more to the state than to the IRS, said Rod Mauszycki, principal with CliftonLarsonAllen in Minneapolis, and DTN/The Progressive Farmer’s tax columnist. “Although I’m confident that a fix will be adopted, it might not be quick enough. As a result, we may have to delay filing the 2018 tax returns.”
Without 1031 exchanges, the tax treatment of trade-ins becomes more complicated. It’s just one way changes to the tax code are forcing farmers to change their mindset. In this four-part series, DTN explains how to maximize deductions by avoiding losses, how to navigate new rules for equipment and why it might be a good time to change your farm’s corporate structure to take advantage of lower tax rates and reconsider gifting strategies.
TWO TRANSACTIONS FOR TAX PURPOSES OFFSET BY BETTER DEPRECIATION
The amount of equipment and software that can be depreciated in a given year has been increased from $500,000 in 2017 to $1 million in 2018. The phase out for the $1-million availability begins after equipment purchases exceed $2.5 million in a given year. However, beginning Sept. 28, 2017, until the end of 2022, 100% bonus depreciation applies to almost all purchases of farm property, including used property. The bonus depreciation phases out beginning in 2023.
Additionally, new farm equipment can now be depreciated over five years rather than the seven years previously allowed. However, used farm equipment depreciation continues with a seven-year life.
Because Congress eliminated like-kind exchanges for equipment — it kept the provision for real estate transactions — equipment trades will now be considered as two transactions for tax purposes.
For example, you have a tractor with a trade-in value of $100,000 and a zero tax-basis. You want to trade it for a $200,000 tractor.
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In 2017, you would owe no state or federal income tax on the trade-in, and you would have $100,000 available for depreciation because the dealer gave you credit for your used equipment and subtracted it from the purchase price of the new model. This difference is also known as the boot. You figured depreciation from your cash outlay plus any remaining tax basis on the equipment you traded in.
In 2018, there’s no trade-in. You sell your old tractor to the dealer for $100,000 and pay $100,000 in cash for the new $200,000 tractor. You have an ordinary income gain of $100,000 if your tractor was fully depreciated. You can avoid federal income tax if you claim a Section 179 deduction or use 100% bonus depreciation for qualified property.
“Financially, it still nets out in the end,” Mauszycki said, “but taxpayers need to be aware of it.”
COMPLICATIONS FROM STATE LIMITS ON SECTION 179 DEDUCTION
The rub comes with your state income tax. Brian Lanoue, CPA with Lambert and Lanoue in Monticello, Indiana, said that Indiana allows a maximum Section 179 deduction of $25,000. So, if the farmer in this example lived in Indiana, he would pay taxes on $75,000 of ordinary income (the $100,000 gain minus $25,000 Sec. 179 deduction). In Indiana, with a top state income tax rate of 5%, that’s $3,750.
A higher amount available for depreciation on the transaction would be somewhat offsetting. Instead of depreciating the cash amount of $100,000 after the trade-in, the tax basis for the new tractor would be $200,000 since it is treated as a sale and purchase.
Tax experts agree that depreciation is one of the most complicated parts of the tax code, with different federal and state rules adding to the complexity. For example, Wisconsin allows Section 179 depreciation in its entirety but significantly limits bonus depreciation.
Seven states limit Section 179 deduction to $25,000: Indiana, Arkansas, California, Kentucky, Maryland, New Hampshire and New Jersey. Iowa has a limit of $70,000 for a Section 179 deduction.
Minnesota’s rule is extremely complicated: The limit for Section 179 deduction is $25,000 plus you “add back 80% of the difference from the increased federal section 179 expense deduction and the Minnesota limit,” according to the Minnesota Department of Revenue. Because you no longer base the add back on the “boot,” but the entire purchase price, the farmer might be subject to much larger state taxes in 2018 than in previous years.
“States generally don’t want you to accelerate the depreciation,” Mauszycki said. “They like to make sure they are collecting their revenue up front.”
He expects that, come tax time, there will be considerable pressure in many states for legislators to revamp their tax laws to coincide with the federal law. That has yet to happen in many states.
“Although there are a few bumps in the road, the new treatment of assets could be a blessing,” Mauszycki said. “Due to Section 199A, we are counseling our clients not to have farm losses. The positive is that changes to 1031 exchanges will create additional income for our farm clients that trade assets. That will provide farmers with more opportunity to play with Section 179 to prevent losses and maximize the 199A deduction.”
Professional tax advice is strongly advised before you trade in your equipment. It could make a difference of when, how and how much equipment you trade and buy.
Des Keller contributed to this report.
Editor’s Note: If you’re interested in learning more about how to profit from tax reform and how to strengthen your financial foundation, make sure to attend the DTN Ag Summit in Chicago December 3-5. You can find all of the details at www.dtnagsummit.com.