We met with our accountant today to do our income taxes. We found out we have to come up with money for Uncle Sam we don’t have right now. So why are we happy? Capital gains! For every $10,000 we made with capital gains, we saved $3,000 in tax.
Capital gain is an underutilized tool to reduce tax. We have concentrated on using capital gains to increase our after-tax income. If your farming enterprise typically doesn’t show a profit, this post will have little value to you.
Ordinary income is subject to self employment tax, (social security), which is 15%. Ordinary income is also taxed at increasing brackets beginning with 10% and going to 35%.
Most people think of stock appreciation when they think of capital gains. The Bush years were kind to the capital gain tax rate. Depending on your tax bracket, capital gains were taxed at 5% or 15%. In 2008, according to our accountant, capital gains were taxed at 0% or 15% depending on your tax bracket. Self employment tax is not applied to capital gains either. This is another savings of 15%.
Capital gains occur in livestock farming with the sale of breeding stock. Breeding stock used on your farm. If an animal is used as a parent on your farm then it is breeding stock.
If an animal is sold to another farmer for the purpose of becoming a parent, but was not a parent on your farm, it is classified as ordinary income.
Animals sold as meat are classified as ordinary income, unless the animal was used as breeding stock, and then sold as meat. That would qualify as a capital gain.
How does this work for our farm? We sell many animals for meat. We sell many animals for breeding stock to other farms. The profit from these sales put us into the 15% tax bracket for 2008. We also have to pay the 15% self employment tax on this ordinary income. This means that for every incremental dollar we make, we pay 30% to Uncle Sam.
But for every capital gain dollar we make, we pay no self employment tax and 0% federal tax because we are in the 15% tax bracket. This is a savings of 30%.
Even if we are in a higher tax bracket, the most tax we would have to pay on capital gains would be 15%. This would still be a substantial savings.
So how do we shift more of our income from ordinary to capital gains? Most farmers look at breeding stock as a cost and a net drain to their farm. They select a $600 heifer from within their herd for breeding stock and keep her for her entire productive life of 10 to 15 years. At the end of her productive life, and sold on the commodity market for hamburger, she will only bring $300 to $500. It looks like a loss. The capital gain tax break will make up some of the difference but it still doesn’t look very lucrative.
What if the $600 heifer is kept as breeding stock but sold at a younger age, say 7 years, for $900 or $1000 to another farmer. Now your asset is appreciating and you have the capital gain tax break besides. This is the strategy we have been using.
To make this system work and to keep your herd size constant you will have to keep more replacement heifers. Heifer management and the selection of a calving-ease bull is paramount to success.
Also keep in mind that taxes change all the time. It appears that the 2009 capital gain tax rate will be the same as 2008. This tax break may disappear by 2010. Take advantage of capital gains while you can.