Capital Gains and Understanding Basis

Joseph R. Aker, Attorney at LawAbout the Author: Joe Aker is a 5th generation farmer in Abilene, KS and a Partner with Cottonwood Law Group, LC in Abilene where he practices agricultural law and taxation, estate and business planning, and family law.

Kansas Agricultural property

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Basis is defined as the amount of your capital investment in property for tax purposes. In common terms its what you paid for the property or its value when you acquired it. Basis plays a big role in determining depreciation, recapture, and the dreaded capital gain. This article will discuss how basis in property can affect property transfers.

There are two basic types of property transactions or transfers: transfers during life and transfers after death. Transfers during life are usually viewed as sales or gifts. In the event of a sale during life, the basic rule is that the price the property is sold for minus the property’s basis is your capital gain (or loss). For example, if Ima Farmer bought 160 acres in 1980 for $500 per acre and sold that property in 2019 for $3,500 per acre, Ima Farmer’s gain would be $3,000. We arrive at that figure by subtracting the price the property sold for ($3,500) from Ima Farmer’s basis in the property ($500) – or what he acquired it for. That $3,000 per acre gain is subject to capital gains tax. Depending on Farmer’s tax bracket, it could be up to 40%.

Example 1: Let’s see what Ima Farmer could have done to avoid such a large tax bill. If instead of selling the property, Ima Farmer had instead left it to his heirs in his will or in a trust, at Ima Farmer’s death, the property would have received a step-up in basis under IRC 1014. This provision in the tax code gives Ima Farmer’s heirs the property with the current fair market value as of Farmer’s date of death as their basis in the property. So, using the previous example, if instead of selling the land for $3,500 per acre, Ima Farmer had died and left the land to his heirs, the heirs would take the property and their basis in the property would be $3,500 per acre. Therefore, if the heirs decided to sell the property after Farmer’s death for $3,500 per acre, they would not have any gain because their basis is $3,500.

Example 2: Let’s look at another route Ima Farmer does not want to take in the event his children are planning on selling the property. If instead of selling the property himself and instead of leaving the property to his family after his death, Ima Farmer decides to gift the property to his family during his lifetime. In this scenario, Ima Farmer’s basis of $500 per acre (what he purchased the land for in 1980) is transferred to the family members he gifts the land to. So, instead of receiving a step-up in basis like in the example where Farmer dies and leaves the land to his family, his family steps into the shoes of Ima Farmer and possesses the property with Farmer’s basis. Therefore, if Farmer’s family decides to sell the land, even they wait to sell it after Farmer dies, they will still have a capital gains problem.

Example 3: One way to get around a capital gains problem is to do a 1031 Exchange. How this works is Ima Farmer sells the land (Tract 1), then turns around and buys another piece of land (Tract 2) and Farmer’s basis in Tract 1 is now transferred or substituted as Farmer’s basis for Tract 2. For this to work, timing is important and you also need a qualified intermediary. The IRS requires that the exchange be completed within 180 days. The result of the 1031 exchange is that Tract 1’s basis of $500 per acre is transferred or substituted for Tract 2’s basis. So now, even though Farmer paid $3,500 per acre for Tract 2, his basis in Tract 2 is still $500. In essence, the 1031 exchange allows Farmer to defer any capital gains he received when he sold Tract 1. This is liken to kicking the can down the road, but if the situation is structured correctly, Farmer will die and Tract 2’s basis will receive a 1014 step-up like in Example 1. Now if Farmer’s heirs decide to sell Tract 2 after Farmer’s death, there will be little or no capital gain.

Depending on the situation, one of these examples can be used to avoid a capital gains issue. There are other more complicated ways to manage capital gains tax such as charitable trusts and installment sales, so be sure to speak with your tax preparer and attorney prior to any sale. The examples outlined in this article are dependent on the facts of the situation.

Disclaimer: The information in this article is intended for general informational purposes only. This information is not intended to be, nor should be interpreted as, legal advice or a legal opinion. The reader should not consider this information to be an invitation to an attorney-client relationship, should not rely on the information presented here for any purpose, and should always seek the legal advice of counsel in the appropriate jurisdiction.