The Tax Cuts and Jobs Act has significantly changed the tax landscape for agricultural producers. We’ve detailed a number of the changes, many of them positive, in prior articles. In light of the federal changes, Iowa must now decide how to respond. As Iowa lawmakers turn their attention to tax reform, we review several key IRC § 179 issues with great impact to Iowa agriculture and suggest they warrant attention, especially a glitch in the law that can deny owners of certain pass through entities cost recovery altogether.
Section 179 has long been an important tool for farmers. It helps them with ever-difficult cash flow struggles, lowers their marginal effective tax rate, and eliminates burdensome recordkeeping requirements associated with depreciation. Between 2012 and 2016, farmers claimed 53% to 73% of the IRC § 179 claimed by Iowa taxpayers.[i] Nearly half of the farmers who claimed IRC § 179 had less than $350,000 in gross cash farm income. They were the principal operators of their farms.
Historically, Iowa has not coupled with federal bonus depreciation provisions, but has conformed to federal IRC § 179 provisions. Last year, in light of serious budget concerns, the Iowa Legislature decided not to couple with many federal tax extender provisions, including the increased IRC § 179 made permanent by the 2015 PATH Act. Consequently, during the 2017 filing season (2016 tax year), taxpayers and their preparers for the first time battled with a $500,000 federal IRC § 179 deduction and a corresponding $25,000 Iowa § 179 deduction. And, the federal threshold (or level at which the expense deduction begins to phase out), was $2,010,000, while the Iowa threshold remained at $200,000. This led some Iowa farmers to face significantly higher Iowa tax liability than federal tax liability.
For example, John purchased and placed into service a $300,000 combine in 2016. He took a § 179 deduction for the full cost of the combine on his 2016 federal return. Because the cost of the combine exceeded the Iowa § 179 $200,000 phase-out limit, however, he could not take a § 179 deduction on his Iowa return. John was instead required to begin depreciating the cost of the property on his Iowa return over a seven-year period, using MACRS.
For taxpayers like John, this was a difficult and unexpected scenario, given that Iowa had previously conformed to federal law. But it was primarily a timing issue. He would eventually get to recover his investment cost, although his cash flow would suffer, and he faced the difficulty of keeping two depreciation schedules.
For other taxpayers, the uncoupling of Iowa’s § 179 from the federal limits means that they are denied cost recovery altogether. The deduction is permanently lost. This result, which occurs with taxpayers owning interests in entities, is a glitch rather than a reasoned policy decision. For that reason, it should be corrected. Consider these examples:
Sue is an Iowa taxpayer with ownership interest in three farming partnerships. Each partnership placed $200,000 of property in service in 2016 and passed a $20,000 § 179 deduction to Sue. Sue can take the $60,000 federal § 179 deduction, but is limited to $25,000 for the Iowa § 179 deduction. Here, the $35,000 in excess of the Iowa limit passed to Sue cannot be carried forward. In this case, Sue also cannot depreciate the excess amount using MACRS, even if the partnerships provide proper depreciation information to her. To make matters worse, Sue’s basis in her partnership interests is reduced by the amount of the section 179 deduction passed through from those partnerships, even though she was not allowed to claim the full deduction on her Iowa return. And there is no provision for restoration of the basis when the partnership interests are sold.
If the same tax preparer completed the returns for the three entities or if the tax preparers for the entities could coordinate, this result could be avoided. The partnerships could choose not to take federal IRC § 179 that would be wasted on the Iowa return. Taxpayers could also revoke a § 179 election with an amended return. But such coordination is not always possible. And entirely forfeiting a federal benefit is not desirable.
Consider the non-Iowa S Corporation:
Bill is a shareholder of a family farming S Corporation based in Illinois. The S Corporation has no Iowa activity and files no Iowa return. Bill is an Iowa resident. The S Corporation passed a $90,000 §179 deduction to Bill, and he was limited to a $25,000 deduction on his Iowa return. The $65,000 excess deduction could not be carried forward to future years. Nor could the S Corporation provide information to Bill so that he could depreciate the excess amount using MACRS. Bill lost this deduction entirely. And, as with Sue in the example above, Bill had to reduce his basis in the S Corporation by the entire $90,000, even though he was allowed no corresponding deduction.
Here too, the result was possibly avoided or mitigated if Bill was able to convince the S Corporation to avoid electing federal § 179 in an amount leading to this result. But again, that wasn’t always possible. And it certainly wasn’t desirable.
Also significantly impacted by this “glitch” were fiscal year entities:
Myron and Josephine are partners in a farming partnership. The partnership had a tax year beginning July 1, 2015. Myron and Josephine, however, are calendar year taxpayers. On December 15, 2015, the partnership placed into service a single-purpose agricultural structure costing $400,000. The partnership claimed a $400,000 federal § 179 deduction and was required to claim the same deduction on the Iowa return. Iowa coupled with federal § 179 limits in 2015. The partners each received their $200,000 pass through deduction for the tax year beginning January 1, 2016. They were each limited to a $25,000 Iowa § 179 deduction for 2016. The $175,000 excess deduction for each partner could not be carried forward and deducted in future years. Nor could the partners depreciate the excess amount using MACRS, even though the partnership provided information for the calculation. Again, this deduction was lost permanently AND the partners were each required to reduce their basis by $200,000, resulting in a permanent increase of $175,000 in Iowa income.
Although the fiscal year example arose because the Iowa limit changed in 2016, the other examples are repeating for tax year 2017. Without intervention by the Iowa Legislature, some taxpayers are left to forego a federal § 179 deduction because they don’t want a permanent increase in Iowa taxable income. Others will suffer the loss because they have no ability to forego or revoke the federal election. And fixing the glitch would not be a true revenue hit for Iowa because it would not grant new benefits. It would merely allow the law to correctly reflect the true financial status of the taxpayer.
Increased Federal Limit
These problems stand to grow larger in the wake of the Tax Cuts and Jobs Act. With the 2018 federal IRC § 179 deduction limit permanently increased to $1,000,000 (with a $2.5 million threshold), the discrepancies between state and federal treatment grow. The current Iowa § 179 election is not even indexed for inflation.
No Like-Kind Exchange for Equipment and Livestock
Of great concern to Iowa farmers is the TCJA’s change to IRC § 1031, which limits like-kind exchange treatment to real property. With no § 1031 tax deferral treatment available to personal property in 2018, equipment or livestock “trades” are fully taxable events under federal law. The taxpayer computes gain (or loss) based upon the difference between the amount realized on the sale of the relinquished asset and the adjusted basis in the asset. There is no tax deferral for §1231 gains or §1245 recapture.
This means that a typical farm equipment trade will now likely trigger significant §1245 recapture, which is taxed as ordinary income. Under pre-TCJA law, §1031 tax deferral treatment was mandatory with a trade. This meant the ordinary income from the recapture was not recognized and the tax was deferred:
In 2017, John traded a tractor with a FMV of $75,000 and an adjusted basis of $0, plus $50,000 in cash, for a tractor with a fair market value of $125,000.
Under old law, IRC § 1245 recapture was deferred, and the basis in John’s replacement tractor was $50,000 ($0 basis in relinquished tractor, plus boot paid). John reported the transaction on Form 8824, and could generally use IRC § 179 to immediately expense $50,000, the amount of boot paid in the transaction.
In contrast, the 2018 treatment is as follows:
In 2018, John “trades” a tractor with a FMV of $75,000 and an adjusted basis of $0, plus $50,000 cash, for a tractor with a fair market value of $125,000.
This transaction is a sale and a purchase under federal law. John must now recognize $75,000 in § 1245 recapture. The gain is reported on Part III of Form 4797 and taxed as ordinary income. John’s basis in his new tractor is $125,000, the full purchase price of the tractor. John can likely use federal IRC § 179 to expense that amount in 2018. If Section 179 is not available, he can use 100 percent bonus to capitalize and depreciate the cost of the purchase.
In Iowa, John can expense only $25,000 of his purchase. He will have to depreciate the rest over time. If Iowa eliminates the like-kind exchange treatment for personal property and does not increase the Section 179 limits, John would have to recognize more than $40,000 in additional Iowa income that will not be offset by a corresponding deduction. That’s a significant hit. And if John had qualifying purchases totaling more than $225,000, he would be locked out of § 179 entirely, forced to recognize the entire amount. As of now, Iowa remains coupled to federal tax law as of January 1, 2015, which included like-kind exchange treatment for personal property.
In 2016, it was estimated[ii] that the Iowa § 179 limits impacted a significant number of Iowa farmers. It was estimated that raising Iowa’s § 179 dollar limitation to $100,000 and its phase-out to $400,000 would benefit 8,554 farmers. And raising the deduction to $520,000, with a phase-out of $2,070,000 would impact 9,137 farmers. If Iowa loses like-kind exchange treatment for personal property, these numbers will climb higher.
On February 13, Governor Reynolds unveiled a proposal, SSB 3195, generally designed to lower tax rates and better align Iowa law with new federal tax provisions. The Governor’s proposal would make a few changes for the 2018 tax year, but the bulk of the package—including generally lowering the top individual tax rate from 8.98 percent to 7.60 percent—would take effect in 2019. Also beginning in 2019, the Governor’s plan would increase the IRC § 179 deduction to $100,000, with a threshold of $400,000. It would also appear to allow five-year depreciation where a deduction is denied because of the entity “glitch” detailed above.
On February 21, Senator Feenstra introduced a tax reform proposal, SF 2383, designed to lower rates and better align the Iowa Revenue Code with the TCJA. This proposal, which would also enact its key provisions beginning in 2019, would permanently couple Iowa law with current federal tax law for most provisions, not including bonus depreciation. In other words, Iowa's § 179 would be linked to the federal limits, which would include the $1,000,000 deduction (indexed for inflation) and a $2.5 million threshold (indexed for inflation). The bill passed the Senate late February 28, 2018, by a vote of 29-21.
SF 2383 would remedy the issues detailed above by allowing farmers the full benefit of the IRC § 179 and fixing the entity glitch moving forward. SSB 3195 would mitigate the impact of the issues detailed above by increasing the IRC § 179 limit and allowing partners or S Corporation shareholders to depreciate amounts not allowed to be expensed under IRC § 179. These provisions, if adopted, however, would not be effective until 2019.
Consequently, the entity glitch could cause some taxpayers to face three years of basis adjustments without a corresponding Iowa deduction. As the debates ensue, correcting these entity anomalies should be a priority. A retroactive fix of this problem would be the only way to prevent some taxpayers from incurring permanent and unwarranted increases in Iowa tax liability. Lawmakers should also consider the importance of IRC § 179 in general, particularly to offset the impact of any loss of like-kind exchange tax deferral treatment for trades. As farmers continue to struggle with lower incomes, increased tax liability stemming from equipment trades would only compound cash flow problems.
On February 27, the Legislative Services Agency issued its fiscal analysis of SF 2383. It projects that the bill would cost $207.8 million in FY 2019, $777 million in FY 2020, $941 million in FY 2021, $1.069 billion in FY 2022, and $1.163 billion in FY 2023.
We will be watching as the tax reform debates move to Iowa.
[i] See Jia, Mandy, How Does Section 179 Expensing Impact State Individual Income Tax Revenue: a Case of Iowa (Sept. 2017). Accessed at: https://www.taxadmin.org/assets/docs/Meetings/17rev_est/jia.pdf
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