Welcome Changes to Iowa Capital Gain Deduction Form on the Horizon

Last year, the Iowa Department of Revenue unveiled a new form for claiming the Iowa Capital Gain Deduction. IA 100 was designed to collect key information up-front, rather than after the fact, regarding transactions qualifying for the rather unique Iowa deduction. The change was met with some concern and confusion, particularly among taxpayers (and preparers) reporting transactions involving cattle, horses, or breeding livestock (by far the most common trigger for the deduction). But, rest assured, help is on the way. A new series of forms is in the works. Although there are not yet sample forms to share, it appears these changes will be very welcome. The Iowa Department of Revenue will discuss the updates (including sample forms) at our eight Iowa Federal Income Tax Schools in November and December.

In the meantime, I’ll review the basic rules of the deduction.

How Does the Deduction Work?

Not all states impose a state tax on capital gains. Iowa, however, does. In fact, the same income tax rates apply to all Iowa taxable income, whether stemming from ordinary income or a capital gain. Consequently, Iowa would tax the capital gain from a typical stock sale at a rate of 8.98 percent, the rate that applies to an individual’s taxable income exceeding $69,255 (for tax year 2015). Similarly, if an investor purchased 100 acres of farmland in 1975 for $1,000 per acre and sold that same ground in 2016 for $9,000 per acre, that investor will likely owe up to 8.98 percent in Iowa taxes on $8,000 per acre, the amount of gain.

But Iowa has carved out a small exception to this general rule. Since 1990, the Iowa Legislature has allowed qualifying small business owners and farmers to deduct at least a portion of the capital gains income they realize from the sale of their business-related property. The rules have evolved through the years, but currently, under Iowa Code § 422.7(21), a full capital gain deduction is allowed in Iowa for net capital gain stemming from the sale of the following property:

• Real property (such as farmland) used in a business in which the taxpayer materially participated for 10 years immediately prior to the sale, when that property has been held for a minimum of 10 years immediately prior to its sale.
• A business in which the taxpayer materially participated for 10 years, when that business has been held  for a minimum of 10 years immediately prior to its sale.
• Cattle and horses used for breeding, draft, dairy, or sporting purposes and held for 24 months by the taxpayer who received more than half of his or her gross income from farming. Where the purchaser is a lineal descendent (child, grandchild, stepchild, or adopted child), the income limitation does not apply.
• Breeding livestock other than cattle and horses, held for 12 months by the taxpayer who received more than half of his or her gross income from farming or ranching. Where the purchaser is a lineal descendent (child, grandchild, stepchild, or adopted child), the income limitation does not apply.
• Timber held by the taxpayer for more than one year.

In addition, 50% of the gain from the sale or exchange of employer securities of an Iowa corporation to a qualified Iowa employee stock ownership plan (ESOP) may also be eligible for the Iowa capital gain deduction.

Under these rules, if a farmer who has been farming 800 acres for 12 years decides to sell the farm, that farmer will be able to deduct any capital gain from the sale of that farmland from Iowa income. On the other hand, no Iowa capital gain deduction exists for investment property. Unless the seller materially participates in the farm or business, a capital gain deduction will not be allowed.

Material Participation

The test for material participation is borrowed from federal tax law and set forth in Iowa Administrative Code 701-40.38(1). Generally, a person has materially participated if he or she has been involved in the business on a regular, continuous, and substantial basis for each of the 10 years prior to the sale. While this is a fact-intensive question, there are several tests that fairly conclusively establish material participation. These include:

• The taxpayer participated in the business for more than 500 hours in the tax year.
• The taxpayer’s participation in the business constituted substantially all of the participation of anyone in the business for the tax year.
• The taxpayer participated in the business for more than 100 hours in the tax year, and nobody else spent more time in the business activity than the taxpayer.

A taxpayer who materially participated for five of the past ten years will generally meet the test for material participation. Likewise, a retired or disabled farmer is treated as materially participating in a farming activity for the current year if the farmer materially participated in the activity for five of the last eight years before retiring or becoming disabled. The surviving spouse of a farmer who dies is treated as materially participating for the current tax year if that spouse actively participates in the farm business by making management decisions or arranging for others to provide services, such as custom harvesting. Under these rules, a taxpayer who has always cash-rented farm ground would generally not be eligible for the deduction. A crop share landlord, on the other hand, generally would. Given the fact-intensive nature of the rule, however, there are exceptions to each general statement.

Taxpayers who sell their farm or business property under an installment sale are required to file the Form IA 100 each year to claim the proper portion of the allowed deduction.

The Iowa Department of Revenue offers a number of helpful resources related to the Iowa Capital Gain Deduction on its website. And there will be much more to come at the Iowa Federal Income Tax Schools.