Alabama cattle farmers may be eligible for an extended period of time in which to reinvest the proceeds of livestock sales in order to avoid paying tax on the profits, if the sales were forced by drought conditions. Such sales are considered to be "involuntary conversions" under Internal Revenue Code Section 1033(e)(2), and farmers have up to four years to reinvest the proceeds in property that is "simlar or related in use" to the converted property. A reinvestment within the required period allows the farmer to defer reporting the gain on the sale while reducing the basis of the replacement property by the amount of the gain not reported. The Alabama Code adopts federal Section 1033 by reference(1), so its benefits will be available on the farmer's Alabama return also.
How Does It Work?
Let's assume that Farmer Smith averages selling 10 cows per year from her beef herd, but her hay crop is ravaged by drought in 2007, and because of a lack of available food, she sells 30 cows in that year. She sells the cows for $1,000 each (a total of $30,000), and since she raised them from calves born on her farm, she has no cost basis, so she realizes $30,000 of profit on the sale. The excess of the total livestock sales for the year over the average sales from prior years is the amount eligible to be treated as an involuntary conversion. In Farmer Smith's case this will be the total sales ($30,000) multiplied by a fraction. The fraction is the excess number of cows sold during the year over the average from prior years (30 - 10 = 20) as the numerator, and the total number of cows sold (30) as the denominator. The result ($30,000 x 20/30 = $20,000) is the involuntary conversion amount.
On her 2007 federal and Alabama income tax returns, Farmer Smith will report total livestock sales of $30,000; but she will also claim a deferral of $20,000 of those sales under IRC Section 1033(e)(2). She will need to attach a statement to both tax returns documenting her intention to reinvest the $20,000 in "similar" property, i.e.; beef cattle, by December 31, 2011 (four years following the end of the tax year in which she reported the gain). The statement should also explain how she determined her average annual sales, and should contain the calculations explained in the previous paragraph.
Now, we will assume that some time over the next four years, Farmer Smith buys twenty new cows, and pays $1,500 a head for them (a total of $30,000). Ordinarily, her cost basis in the new cows would be $30,000. However, since she deferred a gain of $20,000 on the 2007 sales, she must adjust her basis on the replacement cows by the same amount. Her basis in the twenty new cows will be the amount paid for them ($30,000) less the deferred 2007 gain ($20,000), or $10,000 ($500 per head).
Farmer Smith doesn't escape paying taxes on her 2007 profits, because when she sells the replacement cows she will have to calculate the profit on those sales using the lower cost basis. Still, she does get to delay the payment of those taxes, and because of the time value of money, a delay in paying out funds is almost always worth money in the form of interest earned or interest expense avoided.
If, for some reason, Farmer Smith fails to reinvest the $20,000 deferred gain within the four year period, she must amend her 2007 return to report the $20,000 in taxable income for that year, and she will have to pay the additional taxes plus interest and penalties.
As with all tax strategies discussed on these pages, you should always be aware that federal and state tax laws are extremely complex, and small differences in individual fact patterns can make large differences in the outcomes. You are strongly urged to consult a competent tax advisor before acting on the information in this article or making any other major business decision.
(1) AL Code §40-18-8(d)
This page last updated 10/3/07
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