Farm scene
DO YOUR HOMEWORK: Given another year of reduced farm income and declining cash rents, now is the time to take a comprehensive look at your property and evaluate what it can most likely produce, before locking into any lease arrangement.

Tax Law Uncertainty Remains An Issue For Farmers

Income tax rates, capital gains and estate taxes are set to increase at end of 2012 unless Congress acts. How can you plan amidst such uncertainty?

There's a big push by farm organizations to get the new 2012 Farm Bill passed in Congress, when lawmakers return to Washington D.C. after the November 6 election. However, the farm bill isn't the biggest concern for Congress. They need to come up with a new tax package. Also, the federal budget issue is once again looming large, as huge automatic cuts in government spending are scheduled to begin January 2, unless Congress takes action.

Tax Law Uncertainty Remains An Issue For Farmers

The so-called "lame duck" session when Congress comes back after the election will be short, and lawmakers have a lot to get done in that brief period before the end of the year. Congress will take time off for Thanksgiving and will likely adjourn by Christmas.

For insight into this tax situation and ideas to help farmers decide what tax strategy they should take before the end of 2012, Wallaces Farmer asked Neil Harl to share his observations. Harl, an emeritus professor of economics and ag policy at Iowa State University, has seen a lot of tax legislation and farm bills come and go in his 40 years of keeping close tabs on these topics.

Headed for "Tax Armageddon" if Congress doesn't take action
A number of income tax breaks expired at the end of 2011. Congress also needs to address tax breaks that are scheduled to expire at the end of 2012. In addition, the lawmakers need to decide what to do about the federal estate tax, also scheduled to "sunset" (back to 2001 levels) at the end of 2012. "If Congress doesn't pass new tax legislation before the end of 2012 we will have a huge set of cuts coming which would severely jolt the U.S. economy," says Harl.

Another big economic setback will come from "sequestration" if Congress doesn't take action soon. Sequestration means automatic cuts in federal spending will take place if Congress and the administration can't agree on how to resolve budget differences.

Congress and administration need to solve budget differences before huge automatic cuts in spending kick in
Last year Congress and President Obama, when they couldn't work out a mutually agreeable plan to reduce government spending and stem the growth in the federal budget deficit, signed off on a sequestration plan. The plan calls for huge cuts in spending—including slashing $1 trillion from the defense budget over the next 10 years. The spending cuts, which would affect many government programs, are set to take effect January 2, 2013 unless Congress comes up with a different plan.


"Such deep cuts in spending could lead to big financial problems," says Harl. "My fear is unless something is done, the U.S. economy will be pushed into another downturn. You can't remove that much federal spending all at once without causing significant problems. Resolving this budget issue is indeed a big job that's facing Congress and the president."

Getting a tax bill passed and signed into law is another issue needing action. That's what Harl is addressing now -- speaking at seminars and meetings this fall. "There is great demand for information as to what will happen after December 31 of this year," he says. "What will happen with capital gains, what will happen with federal estate tax, the gift tax and generation-skipping transfer tax or GSTT, which affect the transfer of farms and other personal property to succeeding generations?"

Budget, tax bill and farm bill are all demanding attention
These three things (budget reconciliation, tax legislation and the farm bill) are all demanding action. And there's little time left for action this year. "I remember one year, 1994, Congress actually passed some important bills pretty close to the end of the year," says Harl. "The key this year is how the election goes. If the election is won by candidates who are critical of the farm bill, who want lower taxes and bigger cuts in spending, there will be a tendency to run out the clock and do very little this year and postpone the work until 2013."

There are people in Congress who believe they should wait on the farm bill because they'll be able to get bigger cuts enacted in food stamps and commodity programs next year. That's a possibility if the election goes their way.

After the election, "we'll be able to see a little more clearly what the new Congress is going to look like and what they'll likely do when they convene in January," Harl adds, "and we'll know who will be in the White House after January 20, 2013."

Meanwhile, more than the usual amount of tax uncertainty remains
As much uncertainty regarding tax legislation is likely to continue through the end of 2012, year-end income tax planning is a bigger challenge than usual for farmers and everyone. Harl says it's a good idea for people to do a year-to-date review of their income, deductions and potential tax now. That way you can be ready to take quick action once it's clear what, if any, tax law changes Congress will make before year-end.

In addition to income tax considerations, estate tax planning is another important question Harl is getting from farmers and attorneys these days. Currently, the federal estate tax, gift tax and generation-skipping transfer tax rules are scheduled to sunset after December 31, 2012. They will revert to the tax laws of 2001 unless Congress extends the present law or comes up with a new tax package.


Currently, the estate tax is levied at a 35% rate and is exempted on property worth less than $5.12 million for individuals. But starting January 1, that exemption is scheduled to drop to $1 million, while the rate will rise to 55%. Republicans and Democrats both worry that such a change could cause a hardship on farm families who own even moderate size farms forcing them to sell off part of their land just to pay the taxes. However, Harl doubts that Congress will allow the law to sunset after 2012.

Should you transfer property now to avoid higher possible estate tax?

So what should a person do now, if anything, before the end of 2012? Should you transfer a farm to the next generation before the estate tax law reverts back to the $1 million exemption and the 55% rate? First, Harl doesn't think going back to that $1 million exemption and 55% rate will be allowed to happen. He thinks Congress is likely to pass a one-year extension of the current tax law if it appears that writing a new tax bill will not be possible early in the 2013 session of the new Congress.

Beyond one year, looking further ahead, Harl says he doesn't think Congress would enact new legislation to go much below the level of what we have presently; the $5.12 million exemption for estate tax purposes. The Obama administration's position favors returning instead to the 2009 structure, with a $3.5 million exemption for individuals and a 45% rate.

Beware of potential capital gains tax bite when gifting land
Harl says he's getting more calls right now on whether big gifts should be made before the end of this year as a strategy to reduce the potential estate tax burden. For example, he recently received this question from an elderly lady who resides in assisted living who has a $5.5 million estate and was contemplating giving a $5 million gift to her grown children. "There are several things to think about before you do that," says Harl.


"First, I don't think Congress or the president, no matter who is elected this November, is going to go back to the $1 million federal estate tax exemption," he says. "There would be huge political repercussions if that would happen. The second thing you need to think about before you give property away is that you should look at how much you paid for that property. In this example with the elderly lady who called me, the farmland is valuable and some of it had been bought for as low as $100 an acre in the 1930s. Today it's worth $8,000 or $9,000 an acre at least. So if you hang onto all that property until you die it wipes out all the gain."

If you give the farm away, the gain doesn't get wiped out, Harl adds. The low, low basis of say $100 an acre carries over to the recipients. It is they alone who could sell it. "I think many people in the next generation, while they may assure their parents or grandparents that they will hang onto the farm, some of those folks in the next generation will want to sell it sooner or later. That becomes a big consideration in helping you make your decision whether or not to give the farm as a gift. You can have a lot of income tax liability on gifts of low basis land, land that was bought in the 1930s, 1940s or even the 1950s."

Clawback--something else to consider before you make a gift
There's also something called a "clawback" to consider when you are deciding whether or not to make a gift. It's a quirk in the federal tax law and Congress may change it, says Harl. If you make, for example, a $5 million gift it could end up (if this provision in the law isn't changed) with as much as $4 million pulled back into the estate for federal estate tax purposes in the year of the death. That would really irritate the heirs.

It's a quirk that says if you make a big gift during a lifetime then you get a credit for that at death and you take the lesser of the exemption on the date you give the gift or the exemption on the date of the death, Harl explains. "We've had mostly increases in this exemption for decades," he notes. "Who would have thought we might go backwards? And that's what this sunset in the current tax law would do if we revert back to the 2001 law after December 31, 2012."

The lesser exemption would be $1 million if you died after you made the gift and you would have, say $4 million that you'd have to pay federal estate tax and gift tax on, if you have a $5 million estate. "Remember, the exemption for 2012 is $5,120,000 and that is shared by gift tax, estate tax and generation-skipping transfer tax," says Harl.

Get good counsel, don't rush to make estate gift decisions

Harl's advice: "Before you get in a hurry to make gifts as part of your estate planning and tax strategy, this is something that needs to be thoroughly thought through and be sure to get sound counsel on. Sit down with an attorney or other tax professional who is knowledgeable on taxes and estate planning."

Also, Harl says you need to think of the likely needs of the individual. Medical coverage in Congress is under attack and we don't know where we'll end up with Medicare and Medicaid coverage. "People who are in their 70s and 80s as far as age is concerned need to think about a worst case scenario," he says. "Would they have enough assets and income to cover medical expenses if those government programs are cutback?"

Would you end up being hurt financially if you made a big gift?
Or would you be hurting because you made that big gift? "Sure, your children would appreciate getting the property now," says Harl. "But I'm also sure they'd be willing to wait until a death occurs within the next few years, and that would then release the risk of you having to live beyond what assets or income you have available to support yourself."

Harl adds, "Heirs should also reflect on the value to them of getting a new income tax basis at death. That would mean the $7,000 or $8,000 of gain on land bought 80 years ago would be wiped out at death if the land is held until death of the owner. Even if the land is not sold later, the new basis means more depreciation on buildings, fences, tile lines and other depreciable assets."

For farm management information and analysis go to ISU's Ag Decision Maker site and Extension farm management specialist Steve Johnson's site

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