Farm Finances: Basis Information
Farm Business Management Update, August/September 2004
By Bill Whittle, Virginia Cooperative Extension Agent, Farm Business Management, NW
The announcement that Pilgrim's Pride is discontinuing its turkey division sent shock waves through Shenandoah Valley agricultural community. The suddenness of this announcement shows why each farmer must be aware of his financial situation. During stressful times when decisions regarding the future direction of the farm must be made, having complete and accurate records is vital. Each farmer sits in a unique position because of his own financial debt is part of financial position. Decisions made by neighbors may not be the best for your financial well being. Ideally, you would have complete farm financial data at your fingertips. As farm manager you must regularly work with your tax preparer and lender to compile a comprehensive financial package useful for making decisions. This package will include at least a balance sheet, inventory of assets, basis in all assets, and depreciation schedules.
Why should you, facing financial decisions, compile this financial information? Financial decisions are best made with your head rather than your heart. Many farmers sell assets such as building lots or timber to provide an infusion of cash during a crisis. This strategy may work; however, it may also create unexpected problems or generate income below expectations because of taxes.
The concept of "Basis" is a key component of the tax code. Unadjusted basis is defined as the amount of money you have invested in property including any mortgages or other obligations you have on the property, whether it is land, buildings, timber, tractors, or purchased livestock. Adjusted basis is increased by additional investment such as an improvement and decreased by any recovered tax credit such as depreciation.
Basis in property and subsequent tax obligations are used for tax management, generation transitioning, and buying and selling of assets. When selling a capital asset, the basis is the amount of money you may recover that is free of taxes. Said another way, taxes required when you sell an asset are based on the difference between your basis and the sale price. Tax regulations, except in specific circumstances relating to certain exchanges of property, do not allow one to defer taxes just because the money is pumped back into the farming operation.
It would be less confusing if that were the entire story. Depreciation taken on depreciable property alters your basis. When that property is sold, taxes may have to be recovered if the sales price is greater than the adjusted basis. This tax regulation requires tax management to prevent paying taxes at the ordinary income tax rate on the recovered amount rather than the capital gains rate.
A gift of property carries with it the giver's basis even if it is exceptionally low for our times. However, inherited property receives a new or stepped up basis, determined by the fair market value of the property on the day the previous owner dies (or six months after death).
The first of two situations where farmers often have problems with basis is not allocating basis to individual components when assets are purchased together, such as a farm that includes land, buildings, fences, timber, etc. Future decisions get confusing when they try to allocate the basis many years after the purchase or inheritance. The second problem occurs when the manager does not realize the tax implications of selling an asset with a low basis. The take-home money may be less than anticipated because taxes required on capital gains had not been calculated. Though the capital gains tax rate has been reduced, it still must be accounted for.
Tax regulations are complicated. Managers need to compile financial information when they are not stressed by the need to make quick decisions. For more thorough assistance on this topic, you should contact your tax preparer and meet during a time of the year when you are not under deadline pressure.
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