Iowa Department of Revenue Rules On The Material Participation Test For Purposes of The Iowa Capital Gains Deduction

August 20, 2009 | Roger McEowen

 

The Iowa Department of Revenue (IDOR) has issued another ruling concerning eligibility for the capital gains deduction.   Iowa law provides for a state income tax deduction for capital gains derived from the sale of real property that is used in a business or from the sale of a business.  Iowa Code §422.7(21).  To get the deduction, the taxpayer, with respect to the property, must have materially participated for 10 years immediately before the sale (or exchange) of the property.  The requirements for material participation mirror the material participation tests under the passive loss rules of I.R.C. §469(h).  That requires involvement with respect to the property in a manner that is regular, continuous and substantial.  In addition, the taxpayer must have “held” the property for 10 years.  

Under the facts of the ruling, the taxpayer owned a farm and materially participated in farming activities for over three decades – from the 1940s until he died in 1981.  The farm was included in the taxpayer’s estate.  Under the terms of the taxpayer’s will, the farmland was held in trust for his surviving spouse.  The spouse had the right to the income from the farm for life with the children that survived her becoming the outright owners of the farm.  For the first two years after Dad’s death, the trust farmed the property.  Then from 1983 until 1995, one of the sons farmed the property under a 50/50 crop-share arrangement with the trust.  Since 1996, one of Dad’s nephews has been cash-renting the farm from the trust.  Eventually, Mom died and the surviving children became the outright owners of the farm.  The children began the process of selling the farm and sought advice as to whether the sale would qualify for the Iowa capital gains exclusion.

IDOR first noted that the 10-year holding requirement had been satisfied – on that issue there was no question that the family had owned the farm for much more than 10 years.  The question was whether the material participation test was satisfied.  On that point, IDOR noted that either the taxpayer or the taxpayer’s spouse can satisfy the test.  In other words, the taxpayer can meet the material participation test by materially participating as can the taxpayer’s spouse – even if a joint return isn’t filed.  But, the test must be satisfied for the ten years immediately preceding the sale of the property.  Here, IDOR noted that the children failed the material participation test.  They hadn’t been farming the property for the immediately preceding 10 years.  Instead, Dad’s nephew had been cash renting the property since 1996.  Thus, the sale of the farmland did not qualify for the Iowa capital gains exclusion.  IDOR Policy Letter No. 09201040 (Jul. 28, 2009).