TIMOTHY D. BACHICHA, CPA
EXTENSION FARM MANAGEMENT SPECIALIST
COLORADO STATE UNIVERSITY COOPERATIVE EXTENSION
Phone (719)852-2871 email slvfrma@coop.ext.colostate.edu
TWO SEPARATE ISSUES:
IRS Code section 451(e):
Think Sales of Market Livestock (primarily)
IRS Code Section 1033(e):
Think Sale or Exchange of Capital Asset
(Breeding Livestock, Draft or Dairy)
Internal Revenue Code Section 451(e) says that a cash-basis farmer who is forced to sell livestock due to drought, flood or other weather related conditions in an area designated as eligible for assistance by the federal government may elect to be taxed on the forced sale income (gain that normally would not have been realized in the year of the forced sale) in the following year if the farmer can show that the income from the sale of the livestock would normally have been reported in the following year.
Section 1033(e) allows for the non-recognition of gain on sale if the taxpayer replaces the livestock within a specified time frame.
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Important points:
1.
These are elections – the taxpayer’s choice at time returns are filed.
2.
The taxpayer must be a “cash-basis farmer”. a.
Cash-basis, not accrual basis. b.
Farmer – principal trade or business is farming or ranching, usually means that more than 2/3 of income must be from farming or ranching.
3.
Forced to sell – sale of livestock must be because of weather related conditions, not just because the market was good at the time.
4.
Area designated… by federal government (plus any contiguous counties).
5.
Under 451, the tax on income will be paid in the following year. The income not really deferred, recognition of income is deferred.
Deferral of income requires a contract, and income must not have been actually or constructively received. (For simplicity, deferred income is used here even though it isn’t quite the correct terminology.)
6.
Must show that income would normally be reported in the following year under usual business practices.
Must attach statement to federal tax return for the year of the sale.
Sample statement is included with to this outline. Statement must contain:
 Basic information about the taxpayer
 Evidence that weather related conditions forced the early sale, and the date the area was designated as eligible by the federal government due to weather –related conditions
 Specific proof of normal numbers and type of animals sold each year, usually the three prior years
 Information about the numbers and types of animals sold this year
 A computation of the income to be deferred
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Important: The election statement must be made separately for each broad generic classification of animals (e,g, hogs, sheep, cattle) and not based on the animals age, sex or breed. A difference must also be made for breeding stock (capital assets) vs. market animals (inventory, including bulls and breeding heifers produced for sale).
Sec. 451 deferral requires that a producer must show that the sale is contrary to usual business practices. However, if the producer does not have a “usual business practice”, for purposes of determining the number of livestock the taxpayer would normally sell, reliance may be placed on the usual business practice of similarly situated taxpayers in the same general region as the taxpayer. This could be a benefit to some producers who in the past have sold at various times of the year for whatever reason, also for a young producer, (or someone for whom the livestock is a new enterprise) who has not established a “usual business practice.”
A taxpayer may take advantage of another provision which allows a deferred like-kind exchange related to involuntary conversion due to weather-related conditions as an alternative to recognizing the income in any year. This discussion takes place a little later.
Why defer income (via Sec. 451 or otherwise)? Several reasons:
1.
Federal income tax bracket differences
2.
Time value of money
3.
Self-employment tax issues
4.
Social Security limits on earnings a.
Changes in 2002 vs 2001
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Considerations for the decision-making process:
1.
Multi-year perspective –ALWAYS!
2.
Income tax should not be the driving force behind management decisions
3.
What does next year look like? Who knows?, but important to have an idea! a.
Larger expenses or larger overall income expected? b.
Changes to personal situation, marriage, divorce, children going to college? c.
Possible expansion or contraction of operation?
4.
Too late for 2001, but with proper information, a decision could have been made to use the Sec. 451 rules to get cash and use it for paying down debt, reducing borrowing requirements, earn interest, purchase supplies in advance, or purchasing needed capital assets.
5.
Again too late for 2001, but a deferred payment contract sometimes makes better sense. Remember the constructive receipt rules!
6.
How does this fit with other elections, especially the Sec. 179 (for 2002, $24,000), the election to use income averaging on Schedule J, any Net Operating Loss carryforwards/carrybacks, and the election to defer the recognition of revenue from crop insurance proceeds.
7.
The decision making process is multi-faceted. Always consider your own individual situation, not your neighbor’s! Always consult your own tax professional who is familiar with your particular situation, early and often.
To think about:
“A FINE is a tax for doing wrong, a TAX is a fine for doing well”
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Involuntary Conversion Rules – Code Section 1033
(Think “Exchange”)
If an involuntary conversion of property occurs, a taxpayer may defer the recognition (i.e., taxation) of any gain realized on the conversion.
This deferral or non-recognition of gain is mandatory if property is directly converted into property that is similar or related in service or use to the converted property.
In the more typical situation, however, where a taxpayer receives insurance proceeds or a condemnation award as compensation for the involuntary conversion, or even sells the livestock due to drought, flood or other weather related conditions, the taxpayer has the option to choose whether to defer the reporting of gain.
In either case, deferral is contingent on the taxpayer's purchase of qualified replacement property within a certain time period.
Generally, the replacement property must be similar or related in service
(or in use) to the involuntarily converted property.
If the converted property is real property held for productive use in the taxpayer's trade or business or held for investment, the replacement property may be "like-kind" property to the converted property.
A taxpayer can defer all of the gain realized on the conversion of property only if he purchases qualified replacement property costing at least as much as the amount realized on the conversion.
However, if the qualified replacement property costs less than the amount realized on the conversion, gain must be recognized to the extent conversion proceeds are not reinvested.
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What Constitutes an Involuntary Conversion – General Rules
To have an involuntary conversion that results in the complete or partial deferral of gain, the following conditions must be satisfied:
• Property must be compulsorily or involuntarily converted (as a result of its destruction in whole or in part, theft, seizure, requisition, condemnation, or threat or imminence of requisition or condemnation);
• The taxpayer must purchase replacement property similar or related in service or use to the converted property, or must purchase stock to acquire control of a corporation owning qualifying replacement property; and
• The taxpayer must make a valid election (unless the conversion is directly into property similar or related in service or use to the converted property, in which case no election is necessary).
Special rules apply to property sold pursuant to reclamation laws; the sale of livestock destroyed by disease or sold on account of drought, flood, or
other weather-related conditions; the conversion of livestock due to environmental contamination; and a few other situations.
The addition of floods or other weather-related conditions applies to sales and exchanges after 1996. This change was an amendment to Section
1033(e) as part of the Taxpayer Relief Act of 1997.
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Definition of a "Compulsory" or "Involuntary" Conversion
The involuntary conversion rules apply to the "compulsory" or "involuntary" conversion of property as a result of its destruction in whole or in part, theft, seizure, requisition, condemnation, or disposition under threat or imminence of requisition or condemnation.
Deemed Involuntary Conversions
There are four situations where special rules apply to characterize the disposition of property as an involuntary conversion. They are:
• sales to effect FCC policy;
• reclamation law sales;
• destruction of diseased livestock; and
• livestock sales on account of drought.
Destruction of Diseased Livestock
Generally, the death or disposition of livestock "by or on account of disease" is an involuntary conversion.
The livestock do not actually have to contract a disease. Thus, if the livestock have been exposed to disease and are then sold on account of this exposure, it is sufficient for involuntary conversion purposes.
Example: Elk Ranches with Chronic Wasting Disease
For purposes of the involuntary conversion rules, the disease does not have to be of epidemic proportions. It is enough that the disease causes the death of livestock, even if the proximate cause of death was a lethal injection given by the State Veterinarian.
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Livestock Sales on Account of Drought, Flood, or Other Weather-
Related Conditions
If a taxpayer sells or exchanges certain livestock "solely on account of drought, flood, or other weather-related conditions" the transaction qualifies for involuntary conversion treatment to the extent the sales or exchanges exceed those sales or exchanges that would have been made in the normal course of the taxpayer's business.
However, if the livestock die before they can be sold, the involuntary conversion rules do not apply. An argument can be made that if the taxpayer derives gain (such as through insurance proceeds) when the livestock perish, that gain should be eligible for §1033 deferral as gain attributable to the
"destruction" of property.
Example—Normal Business Practice
In the past it has been Jim’s practice to sell or exchange annually 1/2 his herd of breeding cows. If there is a drought that required T to sell 3/4 of his herd, only 1/4 of the sales qualifies for involuntary conversion treatment.
To qualify under this rule, the sale or exchange of the livestock need not take place in the drought area. However, the sale or exchange of the livestock must be solely on account of drought conditions that have adversely affected the water, grazing, or other requirements of the livestock, so that the taxpayer is forced to sell or exchange them.
In addition, the livestock must have been held by the taxpayer for draft, breeding, or dairy purposes.
Do horses qualify?
Yes, if held for draft, breeding or dairy purposes.
The replacement livestock must be "functionally" the same as that sold or exchanged, so that breeding or dairy animals cannot replace draft animals.
Poultry are expressly excluded from the definition of "livestock" for purposes of the drought rule.
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What Constitutes Qualifying Replacement Property
For the involuntary conversion rules to apply, the taxpayer must purchase qualifying replacement property that is similar or related in service or use to the converted property.
In the case of real property held for productive use in a trade or business or for investment, qualifying replacement property can be of "like-kind"
(rather than similar or related in service or use) to the converted property.
The IRS focuses on whether there is "similarity in the relationship of the services or uses which the original replacement properties have to the taxpayer-owner."
The "similar or related in service or use" requirement is satisfied if:
• the reinvestment is made in substantially similar property;
• the reinvestment is a substantial continuation of the prior commitment of capital (and not a departure from it);
• the character of the taxpayer's investment has not changed
(notwithstanding the fact that the replacement property does not have to duplicate the converted property); and
• the entire transaction allows a taxpayer whose enjoyment of property has been interrupted without his consent to return as close as possible to
his original position.
There is a special rule that applies if the purchase is from a related
taxpayer. For involuntary conversions occurring after June 8, 1997, deferral of gain is denied for replacement property acquired from a related person if, the aggregate of the amount of realized gain on involuntarily converted property exceeds $100,000.
Remember, the more liberal "like-kind" standard applies only to the replacement of real property which has been (or is under threat of being) condemned, requisitioned, or seized but not to the replacement of real property that has been destroyed.
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Examples of Replacement Property That Is "Similar in Use"
Whether the "similar in use" standard is satisfied is determined by the facts. The following situations have all satisfied the similar or related in service or use standard:
• manufacturing plant replacing a long-term leasehold on a similar plant;
• improvements to existing farmland or the purchase of adjacent farmland replacing an involuntary overflow easement;
• prune, apricot and walnut orchards replacing a truck and cattle farm;
• 18-acre track of unimproved land replacing a nine-acre tract of vacant land adjacent to a manufacturing plant;
• leased gas station replacing land under a leased warehouse;
• leased office and warehouse replacing leased light manufacturing plant;
• residential apartment development replacing leased industrial warehouse;
• apartment building replacing leased filling station or office building;
• planting a new crop, or purchasing a standing or harvested crop, replacing a standing crop;
• the purchase of all outstanding interest in a partnership owning property similar to that which was converted;
• land needing clearing before it could be used as a building site replacing a cleared building site;
• stock in a public utility corporation replacing stock in a private utility corporation;
• personal residence replacing a personal residence that was destroyed by fire, even though the replacement property was briefly rented to the taxpayers' neighbor; and
• timber cutting contract with one person replacing timber cutting contract with another person.
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Examples of Replacement Property That Is Not "Similar in Use"
Examples of replacement property that is not similar or related in service or use to the converted property include:
• improved real estate replacing unimproved real estate;
• barge replacing requisitioned tug;
• interest in a real estate investment trust replacing leased commercial building;
• savings account and bond replacing investment real estate;
• art work in a different medium from that of the converted art work;
• billiard facilities replacing bowling facilities;
• owner-operated motel replacing owner-operated mobile home parks;
• printing company replacing car wash;
• commercial building to be leased replacing leased farmland or leased parking lot;
• owner-occupied residence replacing leased residence or other rental property;
• leased hotel replacing hotel that the taxpayer operated;
• owned and managed hotel replacing owned and managed commercial office building;
• building used for bank offices replacing office building leased to tenants;
• office building replacing drive-in theater and farm;
• shopping center replacing undeveloped land;
• leased restaurant replacing owner-operated motel;
• farm tractor replacing farm truck;
• shopping mall replacing drive-in theater; and
• fourteen-unit hotel replacing three-unit apartment building.
• timber (or real estate containing timber) replacing contract to cut timber
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Replacement Property Must Be Acquired to
Replace Converted Property
The replacement property must be purchased for the purpose of replacing the converted property. This requirement may provide a trap for those who purchase or acquire the replacement property in the ordinary course of business especially if the taxpayer would have acquired the "replacement" property even absent the conversion.
The IRS has been liberal in allowing deferral in situations where the "intent to replace" requirement arguably was not satisfied. For example, deferral was permitted where there was a condemnation of an orchard and the replacement property consisted of both the purchase of uncultivated land and its replanting. Deferral was also permitted where the replacement property under a modernization program was ordered prior to the destruction of the converted property.
The taxpayer should document and preserve evidence showing that the acquisition was to replace the converted property.
Property purchased before the converted property is disposed of is considered to have been purchased for the purpose of replacing the converted property only if the property is held by the taxpayer on the date the converted property is disposed of.
To qualify for the benefits of the involuntary conversion rules, the replacement property (or stock in a corporation owning the replacement property), must be "purchased."
A taxpayer is considered to have purchased property (or stock) only if, under the normal principles of taxation, the taxpayer's basis in the
property is its cost.
In other words, replacement property acquired by gift, or in a tax-free
exchange, is not eligible for deferral since the basis of the property is not cost.
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Farm Property Replacing Livestock
A special definition of replacement property exists for livestock that are involuntarily converted.
If reinvestment in similar use property (i.e., other livestock) is not feasible because of soil contamination or other environmental contamination, livestock may be replaced by any other property "used for farming purposes."
Thus, dairy cows can be replaced with draft or breeding animals and livestock can be replaced with real property. For this purpose, "livestock" includes poultry.
However, the IRS has interpreted the rule as not applying to a situation involving a taxpayer who was forced to sell brucellosis-infected cattle.
The Service's position was that the rule applies only where toxic chemicals are the contaminant. Thus, because brucellosis is a bacterial infection that leaves the land unfit for livestock for a substantial period of time, the taxpayer's replacement of the livestock with a horse training facility was not a qualifying replacement.
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Period During Which Replacement Must Occur
The taxpayer must replace the converted property within a two-year period.
In measuring this period, time begins to run on the date that is the earlier of either:
(1) the disposition of the converted property; or
(2) the threat or imminence of requisition or condemnation of the converted property.
The period ends two years after the close of the first taxable year in which any part of the gain on the conversion is realized.
Conversion gain is considered realized when, under general principles of taxation, the taxpayer has actual or constructive receipt of conversion proceeds in excess of the property's basis, even though the taxpayer may have a contingent liability to repay the proceeds to the condemning authority.
In one case, the IRS ruled that this is the rule even if some of the money is received after the replacement period.
Replacement of the converted property must be completed by the end of the period. Merely exerting best efforts to replace property within the period is not adequate.
Even the fact that replacement property is not available does not stop the running of the replacement period.
Under certain circumstances the IRS can grant an extension of time of up to one year to replace the converted property. The danger is that such permission is only granted when the time is up, and they may not grant it anyway.
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Making the Involuntary Conversion Election
Electing to Purchase Similar Use or Like-Kind Property
If property is involuntarily converted into money (or other nonqualifying property) and the taxpayer purchases similar use property within the statutory period, the taxpayer can elect whether or not to defer recognition of any gain on the conversion.
The involuntary conversion deferral is elected by including only the gain from the conversion that may not be deferred on the taxpayer's income tax return for the year in which the gain is realized. In other words, only report the gain that is not deferred.
All of the details in connection with an involuntary conversion of property at a gain must be provided on that return, and those details should include what replacement property was acquired, the date it was acquired, and the cost of the property to the taxpayer.
However, if the taxpayer does not include with the relevant return any gain that would, without the benefit of the involuntary conversion rule, be included in income, that taxpayer will be considered to have made an election
even though the details concerning the conversion are not reported.
The tax liability for the year or years in which an election is made is recomputed by filing an amended return if, after having made an election:
• the converted property is not replaced within the required period of time;
• the replacement property costs less than what was anticipated at the time of the election;
• a decision is made not to purchase qualified replacement property; or
• any of the other conditions for qualifying under the involuntary conversion rules are not met.
All this is similar to the treatment of a Section 1031 Deferred Like-kind
Exchange.
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A taxpayer can change a prior election.
The failure of a taxpayer to make an election is not irrevocable. If the taxpayer chooses to make an election after filing a return and paying the tax on the conversion gain, the taxpayer may do so if the replacement period has not yet expired, by filing an amended return for the period in which the gain was originally reported.
A valid involuntary conversion election may be changed or revoked in only three situations:
• if the replacement property does not in fact qualify as replacement property;
• if replacement is made at a cost lower than anticipated;
• if the change or revocation is made before replacement property is actually purchased.
Amended returns must be filed for all periods affected.
Specific details must be reported for the taxable year or years in which any gain from these conversions is realized.
The details for a sale or destruction of diseased livestock must include a recital of the evidence that the livestock were destroyed or sold because of disease.
The details in connection with the disposition of livestock on account of drought must include:
• evidence of the drought condition;
• the amount of gain realized on the sale or exchange;
• the number and kind of livestock sold or exchanged; and
• the number that would have been sold or exchanged under normal business practices.
See attached sample election form.
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Bottom line: Make sure you are consulting a competent professional to advise you in these matters. If you insist on preparing your own tax returns you will get what you pay for.
The information presented herein is deemed accurate at the time it was prepared, however Colorado
State University Cooperative Extension assumes no liability for how it is used. Individuals are encouraged to seek the assistance of qualified professionals in determining how these topics will affect them before making any decisions.
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