I think I am missing your point. What does the rancher do to generate a capital gain?
Glad you asked. From Dr. Ferrell
So you want to know about Senate Bill 1086, the Oklahoma capital gains deduction, and how it might impact farmers and ranchers (and anyone else, for that matter)? Grab a beverage and settle in, because this is gonna take a while...
Recent days have seen much discussion about the capital gains tax exemption in Oklahoma, and that discussion has become much more intense since the announcement that passage of Senate Bill 1086 is one of the two requirements (along with re-enactment of the $5 hotel tax proposed in an earlier revenue package) announced by OEA as a requirement to end the teacher walkout (see
http://bit.ly/2IAV3bw). I have received a number of questions about what the passage of SB1086 would mean, particularly for agriculture, so I have prepared a very brief analysis here (you might not think it's that brief, but trust me, it could be WAY longer). This analysis is not intended to be a statement in support of or opposition to passage of SB1086, but rather an objective analysis to help you determine the bill’s potential impacts to you.
WHAT DOES SB 1086 PROPOSE?
SB 1086 (full text here:
http://bit.ly/2Js2J0Z) would eliminate the exemption of capital gains income from Oklahoma income tax. Under current Oklahoma law, an Oklahoma taxpayer takes their federal adjusted gross income and makes specified additions or subtractions to arrive at Oklahoma taxable income. As Oklahoma law currently stands, the amount of “capital gains” reported for federal tax purposes can be deducted from the income of individuals and corporations (and other entities, such as LLCs) when calculating Oklahoma taxable income. SB 1086 would eliminate that deduction for both individuals and corporations with respect to any capital gains transactions occurring after December 31, 2018.
WHAT IS A CAPITAL GAINS TRANSACTION?
To understand this question, you need to understand what your “tax basis” in an item is. If I buy a piece of land in a normal, arms-length transaction (there are dozens of other ways the transaction could happen, of course), my tax basis in that piece of property is the price I paid for it. If I buy the land for $1,500/acre, my tax basis in the land is $1,500/acre. If I hold the land for the required "holding period" (Oklahoma holding periods vary, as discussed later), then sell it for $2,500/acre, the amount by which the sale price exceeds the tax basis is treated as a capital gain. In this case, I have $1,000/acre in capital gains ($2,500 sale price - $1,500 tax basis = $1,000 capital gain).
At the federal level, capital gains are taxed a much lower rates than “ordinary income.” The amount of capital gains tax paid depends on the federally-taxable income of the taxpayer. Depending on your income, federal capital gains tax rates are 0%, 15%, or 20%. However, the amount of the capital gain (and not the amount of capital gains tax paid) is deducted from taxable income under current Oklahoma law if the required Oklahoma holding period is met.
If SB 1086 is passed, capital gains would not be allowed as an adjustment from Oklahoma income to determine Oklahoma taxable income; rather, the amount of capital gains would be considered ordinary income and taxed at your Oklahoma marginal tax rate (Oklahoma's current rates top out at 5.0%).
WHAT ARE SOME COMMON CAPITAL GAINS TRANSACTIONS IN AGRICULTURE?
One example is mentioned above – the sale of land that has increased in value since its purchase. Note that the treatment of the sale price of land that was inherited or received through a trust after the initial owner died is different (that, too, is another discussion).
If you have purchased company stock or other investments and those investments increased in value, the increase in value might also be a capital gain depending on the nature of the stock and if you held the stock for the required holding period.
Capital gain treatment does not impact most equipment in agriculture since equipment generally depreciates and is sold for less money than it was purchased (handling “depreciation recapture” is also another discussion, though I will mention it briefly below).
However, there is one area of agriculture where understanding capital gains can be even more confusing than usual, and that is with breeding livestock (and note, the following discussion does not apply to stocker or feeder animals). When it comes to capital gains in breeding livestock transactions, there is a difference between purchased breeding animals and raised breeding animals.
Let’s consider a breeding bull. If I bought the bull for $5,000 four years ago and took $4,000 in depreciation deductions, its tax basis is now $1,000. If I sell the bull for $1,250, then $250 (the amount of the sale price over my tax basis in the bull; $1,250 sale price - $1,000 tax basis = $250) is taxed as ordinary income since it is “recaptured” depreciation. The remaining amount of the sale price, $1,000, is not taxable since it represents the tax basis I already had in the bull. In this situation, there is no capital gain.
On the other hand, if I raised the breeding bull myself, my tax basis in the bull is $0.00. If I use the bull for five years (my "holding period") and then sell him for $1,000, the entire sale price would be treated as a capital gain ($1,000 sale price - $0.00 tax basis = $1,000). Under current tax law, the $1,000 would be taxed at my capital gains rate at the federal level, and would be excluded from my Oklahoma taxable income. If SB1086 is enacted, the $1,000 would be added to my Oklahoma taxable income and taxed as ordinary income for my Oklahoma taxes.
What about culled breeding cows? If I bought a breeding cow for $1,000 and took $750 in depreciation against her over five years (again meaning I have a five-year holding period), her tax basis is now $250. If I cull her from the herd and she sells for $300, then $50 (the amount by which her sale price exceeds her tax basis; $300 sale price - $250 tax basis = $50) is treated as recaptured depreciation. The remaining $250, which is her tax basis, is not taxed. However, if the cow was raised by me rather than purchased, my tax basis in her was $0.00; if she is culled and sold for $300, all $300 would be considered capital gains. Under current law, that $300 would be taxed at my federal capital gains rate and would be excluded from Oklahoma taxable income. If SB 1086 is passed, the $300 would be added to my Oklahoma taxable income and taxed as ordinary income for my Oklahoma taxes.
WHAT IS THE REQUIRED HOLDING PERIOD FOR ASSETS TO GET THE CAPITAL GAIN EXEMPTION?
As discussed in several of the examples above, the “holding period” (the amount of time you owned an asset that has gained value over its tax basis) matters in determining whether you can claim some or all of the asset’s sale value as a capital gain.
As Oklahoma law stands right now, you can deduct qualifying gains receiving capital treatment which are included in federal Adjusted Gross Income (AGI) from your Oklahoma taxable income. “Qualifying gains receiving capital treatment” means the amount of net capital gains, as defined under federal Internal Revenue Code (IRC) Section 1222(11). The qualifying gain must:
1) Be earned on real property (land) or tangible personal property located within Oklahoma that you have owned for at least five uninterrupted years (the “holding period”) prior to the date of the sale;
2) Be earned on the sale of stock or ownership interest in an Oklahoma headquartered company, limited liability company, or partnership where such stock or ownership interest has been owned by you for at least two uninterrupted years prior to the date of the sale; or
3) Be earned on the sale of real property, tangible personal property, or intangible personal property located within Oklahoma as part of the sale of all or substantially all of the assets of an Oklahoma headquartered company, limited liability company, or partnership or an Oklahoma proprietorship business enterprise or owned by the owners of such entity or business enterprise for a period of at least two uninterrupted years prior to the date of the sale (in other words, the business is liquidating).
HOW DO I DETERMINE THE IMPACT TO MY TAXES IF SB 1086 PASSES?
Of course, determining this means knowing what your taxable income will be in the future, and that is obviously difficult in agriculture. Past tax returns can be a place to start in determining your average taxable income. You could then add your average or estimated revenues from the sale of raised breeding livestock to Oklahoma taxable income to estimate the change in Oklahoma income tax. The potential tax liability arising from sales of stocks or land can be calculated from the tax basis of the property and using an estimated sale price as well.
CONCLUSION
If you anticipate the sale of assets for more than your tax basis in those assets (and remember that your tax basis in raised breeding livestock is zero), SB 1086 will have an impact on your taxes, but the amount of that impact depends on your taxable income, the tax basis you hold in the property, and your sale price. To calculate the potential impact, gather as much information as you can about the tax basis in all of your property and work with your tax professional to estimate the potential tax liability of any asset sales you are likely to make in the future.
