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Publication 225
Farmer's Tax Guide

For use in preparing 2002 Returns

Acknowledgment:

The valuable advice and assistance given us each year by the National Farm Income Tax Extension Committee is gratefully acknowledged.

11. Dispositions of Property Used
in Farming

Introduction

When you dispose of property used in your farm business, your taxable gain or loss is usually a section 1231 gain or loss. Its treatment as ordinary income, which is taxed at the same rates as wages and interest income, or capital gain, which is generally taxed at lower rates, is determined under the rules for section 1231 transactions.

When you dispose of depreciable property (section 1245 property or section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any gain remaining after applying the depreciation recapture rules is a section 1231 gain, which may be taxed as a capital gain.

Gains and losses from property used in farming are reported on Form 4797. Table 11-1 contains examples of items reported on Form 4797 and refers to the part of that form on which they first should be reported. Chapter 20, Sample Return, contains a sample filled-in Form 4797.

Topics

This chapter discusses:

  • Section 1231 gains and losses
  • Depreciation recapture
  • Other gains

Useful Items

You may want to see:

Publication

  • 544   Sales and Other Dispositions
    of Assets

Form (and Instructions)

  • 4797   Sales of Business Property

See chapter 21 for information about getting publications and forms.

Section 1231
Gains and Losses

Section 1231 gains and losses are the taxable gains and losses from section 1231 transactions - generally, dispositions of property used in business. Their treatment as ordinary or capital depends on whether you have a net gain or a net loss from all your section 1231 transactions in the tax year.

Table 11-1.Where To Report Items on Form 4797
Type of property Held 1 year or less Held longer than 1 year
1 Depreciable trade or business property:
a  Sold or exchanged at a gain Part II Part III (1245, 1250)
b  Sold or exchanged at a loss Part II Part I
2 Depreciable residential rental property:
a  Sold or exchanged at a gain Part II Part III (1250)
b  Sold or exchanged at a loss Part II Part I
3 Farm land held less than 10 years for which soil, water, or land clearing expenses were deducted:
a  Sold at a gain Part II Part III (1252)
b  Sold at a loss Part II Part I
4 Disposition of cost-sharing payment property described in section 126 Part II Part III (1255)
5 Cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less than 24 mos. Held 24 mos. or longer
a Sold at a gain Part II Part III (1245)
b  Sold at a loss Part II Part I
c  Raised cattle and horses sold at a gain Part II Part I
6 Livestock other than cattle and horses used in a trade or business for draft, breeding, dairy, or sporting purposes: Held less than 12 mos. Held 12 mos. or longer
a  Sold at a gain Part II Part III (1245)
b  Sold at a loss Part II Part I
c  Raised livestock sold at a gain Part II Part I

CAUTION: If you have a gain from a section 1231 transaction, first determine whether any of the gain is ordinary income under the depreciation recapture rules (explained later). Do not take that gain into account as section 1231 gain.

Section 1231 transactions.   Gain or loss on the following transactions is subject to section 1231 treatment.

  • Sale or exchange of cattle and horses. The cattle and horses must be held for draft, breeding, dairy, or sporting purposes and held for 2 years or longer.
  • Sale or exchange of other livestock. This livestock must be held for draft, breeding, dairy, or sporting purposes and held for 1 year or longer. Other livestock includes hogs, mules, sheep, and goats, but does not include poultry.
  • Sale or exchange of depreciable personal property. This property must be used in your business and held longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade or business. Examples of depreciable personal property include farm machinery and trucks. It also includes amortizable section 197 intangibles.
  • Sale or exchange of real estate. This property must be used in your business and held longer than 1 year. Examples are your farm or ranch (including barns and sheds).
  • Sale or exchange of unharvested crops. The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person, and the land must have been held longer than 1 year. You cannot keep any right or option to reacquire the land directly or indirectly (other than a right customarily incident to a mortgage or other security transaction). Growing crops sold with a lease on the land, even if sold to the same person in a single transaction, are not included.
  • Distributive share of partnership gains and losses. Your distributive share must be from the sale or exchange of property listed earlier and held longer than 1 year (or for the required period for certain livestock).
  • Cutting or disposal of timber. You must treat the cutting or disposal of timber as a sale, as described in chapter 10 under Timber.
  • Condemnation. The condemned property (defined in chapter 13) must have been held longer than 1 year. It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be property held for personal use.
  • Casualty or theft. The casualty or theft must have affected business property, property held for the production of rents or royalties, or investment property (such as notes and bonds). You must have held the property longer than 1 year. However, if your casualty or theft losses are more than your casualty or theft gains, neither the gains nor the losses are taken into account in the section 1231 computation. Section 1231 does not apply to personal casualty gains and losses. See chapter 13 for information on how to treat these gains and losses.

Property for sale to customers.   A sale, exchange, or involuntary conversion of property held mainly for sale to customers is not a section 1231 transaction. If you will get back all, or nearly all, of your investment in the property by selling it rather than by using it up in your business, it is property held mainly for sale to customers.

Treatment as ordinary or capital.   To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the year.

  • If you have a net section 1231 loss, it is an ordinary loss.
  • If you have a net section 1231 gain, it is ordinary income up to your nonrecaptured section 1231 losses from previous years, explained next. The rest, if any, is long-term capital gain.

Nonrecaptured section 1231 losses.   Your nonrecaptured section 1231 losses are your net section 1231 losses for the previous 5 years that have not been applied against a net section 1231 gain by treating the gain as ordinary income. These losses are applied against your net section 1231 gain beginning with the earliest loss in the 5-year period.

Example.   In 2002 Ben has a $2,000 net section 1231 gain. To figure how much he has to report as ordinary income and long-term capital gain, he must first determine his section 1231 gains and losses from the previous 5-year period. From 1997 through 2001 he had the following section 1231 gains and losses.

Year Amount
1997
1998
1999 ($2,500)
2000 -0-
2001 $1,800

Using this information, Ben figures how to report his net section 1231 gain for 2002 as shown below.

1) Net section 1231 gain (2002) $2,000
2) Net section 1231 loss (1999) ($2,500)  
3) Net section 1231 gain (2001) 1,800  
4) Remaining net section 1231 loss ($700)  
5) Gain treated as ordinary income $700
6) Gain treated as long-term capital gain $1,300

His net section 1231 loss from 1999 is completely recaptured in 2002.

Depreciation Recapture

If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if it is otherwise nontaxable) as ordinary income.

Section 1245 Property

A gain on the disposition of section 1245 property is treated as ordinary income to the extent of depreciation allowed or allowable. See Gain Treated as Ordinary Income, later.

Any recognized gain that is more than the part that is ordinary income because of depreciation is a section 1231 gain. See Treatment as ordinary or capital under Section 1231 Gains and Losses, earlier.

Defined.   Section 1245 property includes any property that is or has been subject to an allowance for depreciation or amortization and is any of the following types of property.

  1. Personal property (either tangible or intangible).
  2. Other tangible property (except buildings and their structural components) used as any of the following.
    1. An integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services.
    2. A research facility in any of the activities in (a).
    3. A facility in any of the activities in (a) for the bulk storage of fungible commodities.
  3. That part of real property (not included in (2)) with an adjusted basis reduced by certain amortization deductions (including those for certified pollution control facilities, child-care facilities, removal of architectural barriers to persons with disabilities and the elderly, or reforestation expenses) or a section 179 deduction.
  4. Single purpose agricultural (livestock) or horticultural structures.
  5. Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum.

Buildings and structural components.   Section 1245 property does not include buildings and structural components. The term building includes a house, barn, warehouse, or garage. The term structural component includes walls, floors, windows, doors, central air conditioning systems, light fixtures, etc.

Do not treat a structure that is essentially machinery or equipment as a building or structural component. Also, do not treat a structure that houses property used as an integral part of an activity as a building or structural component if the structure's use is so closely related to the property's use that the structure can be expected to be replaced when the property it initially houses is replaced.

The fact that the structure is specially designed to withstand the stress and other demands of the property and cannot be used economically for other purposes indicates it is closely related to the use of the property it houses. Structures such as oil and gas storage tanks, grain storage bins, and silos are not treated as buildings, but as section 1245 property.

Facility for bulk storage of fungible commodities.   This is a facility used mainly for the bulk storage of fungible commodities. Bulk storage means storage of a commodity in a large mass before it is used. For example, if a facility is used to store sorted and boxed oranges, it is not used for bulk storage. To be fungible, a commodity must be such that one part may be used in place of another.

Gain Treated as Ordinary Income

The gain treated as ordinary income on the sale, exchange, or involuntary conversion of section 1245 property, including a sale and leaseback transaction, is the lesser of the following amounts.

  1. The depreciation and amortization allowed or allowable on the property.
  2. The gain realized on the disposition (the amount realized from the disposition minus the adjusted basis of the property).

For any other disposition of section 1245 property, ordinary income is the lesser of (1) above or the amount by which its fair market value is more than its adjusted basis. See chapter 3 of Publication 544.

Use Part III of Form 4797 to figure the ordinary income part of the gain.

Depreciation taken on other property or by other taxpayers.   Depreciation and amortization include the amounts you claimed on the section 1245 property as well as the following depreciation and amortization amounts.

  • Amounts you claimed on property you exchanged for, or converted to, your section 1245 property in a like-kind exchange or involuntary conversion.
  • Amounts a previous owner of the section 1245 property claimed if your basis is determined with reference to that person's adjusted basis (for example, the donor's depreciation deductions on property you received as a gift).

Example.   Jeff Free paid $120,000 for a tractor in 2000. He depreciated it using the 150% declining balance method. The tractor is 7-year property. In February 2001 he traded it for a chopper and paid an additional $30,000. To figure his depreciation deduction for 2002, Jeff continues to use the basis of the tractor as he would have before the trade to depreciate the chopper. Because this is the third year of depreciation, he takes a deduction of $18,036 ($120,000 × .1503).

Jeff can also depreciate the additional $30,000 basis on the chopper. Because this is the first year of depreciation on the $30,000, he takes a depreciation deduction of $3,213 ($30,000 × .1071). The total depreciation he can deduct is $21,249 ($18,036 + $3,213). Unless Jeff disposes of the chopper before the end of the recovery period, he can continue to depreciate the $120,000 for 5 more years and the $30,000 for 7 more years.

Depreciation and amortization.   Depreciation and amortization deductions that must be recaptured as ordinary income include (but are not limited to) the following items.

  1. Ordinary depreciation deductions.
  2. The special depreciation allowance for property acquired after September 10, 2001.
  3. Amortization deductions for all the following costs.
    1. Acquiring a lease.
    2. Lessee improvements.
    3. Pollution control facilities.
    4. Reforestation expenses.
    5. Section 197 intangibles.
    6. Child care facility expenses incurred before 1982.
    7. Franchises, trademarks, and trade names acquired before August 11, 1993.
  4. The section 179 deduction.
  5. Deductions for all the following costs.
    1. Removing barriers to the disabled and the elderly.
    2. Tertiary injectant expenses.
    3. Depreciable clean-fuel vehicles and refueling property (minus any recaptured deduction).
  6. Any basis reduction for the investment credit (minus any basis increase for a credit recapture).
  7. Any basis reduction for the qualified electric vehicle credit (minus any basis increase for a credit recapture).

Example.   You file your returns on a calendar year basis. In February 2000, you bought and placed in service for 100% use in your farming business a light-duty truck (5-year property) that cost $10,000. You used the half-year convention, and your MACRS deductions for the truck were $1,500 in 2000 and $2,550 in 2001. You did not take the section 179 deduction on it. You sold the truck in May 2002 for $7,000. The MACRS deduction in 2002, the year of sale, is $893 (½ of $1,785). Figure the gain treated as ordinary income as follows.

1) Amount realized $7,000
2) Cost (February 2000) $10,000  
3) Depreciation allowed or allowable (MACRS deductions: $1,500 + $2,550 + $893) 4,943  
4) Adjusted basis (subtract line 3 from line 2) $5,057
5) Gain realized (subtract line 4 from line 1) 1,943
6) Gain treated as ordinary income (lesser of line 3 or line 5) $1,943

Depreciation allowed or allowable.   You generally use the greater of the depreciation allowed or allowable when figuring the part of gain to report as ordinary income. If, in prior years, you have consistently taken proper deductions under one method, the amount allowed for your prior years will not be increased even though a greater amount would have been allowed under another proper method. If you did not take any deduction at all for depreciation, your adjustments to basis for depreciation allowable are figured by using the straight line method.

This treatment applies only when figuring what part of the gain is treated as ordinary income under the rules for section 1245 depreciation recapture.

Disposition of plants and animals.   If you made the choice not to apply the uniform capitalization rules (see chapter 7), you must treat any plant you produce, or any animal you produced in 1987 or 1988, as section 1245 property. If you have a gain on the property's disposition, you must recapture the preproductive expenses you would have capitalized if you had not made the choice by treating the gain, up to the amount of these expenses, as ordinary income. For section 1231 transactions, show these expenses as depreciation on line 22, Part III, of Form 4797. For plant sales that are reported on Schedule F, this recapture rule does not change the reporting of income because the gain is already ordinary income. You can use the farm-price method or the unit-livestock-price method discussed in chapter 3 to figure these expenses.

Example.   Janet Maple sold her apple orchard in 2002 for $80,000. Her adjusted basis at the time of sale was $60,000. She bought the orchard in 1995, but the trees did not produce a crop until 1998. Her preproductive expenses were $6,000. She chose not to apply the uniform capitalization rules. Janet must treat $6,000 of the gain as ordinary income.

Livestock costs incurred before 1989.   For livestock costs incurred before 1989, the IRS provided two safe-harbor choices for applying the uniform capitalization rules. These safe-harbor choices were not available to corporations, partnerships, or tax shelters required to use an accrual method of accounting. For information on these choices, see Notice 88-24 in Cumulative Bulletin 1988-1 and Notice 88-113 modifying Notice 88-24 in Cumulative Bulletin 1988-2.

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