Policy letter; capital gains deduction; May10,2004
Topic Code: C012Capital Gains Deduction Document Reference: 04201055
May 10, 2004
RE: Iowa Capital Gains Deduction, your letter dated April 20, 2004Dear :Your letter dated April 20, 2004 has been referred to me for reply. Your letter requested a determination on whether an Iowa capital gain deduction can be claimed based on certain factual situations.In all of the situations posed in your letter, the asset involved was farmland involving a husband and wife. The husband materially participated in farming and farmed the owned land until retirement. The husband/farmer and his wife actively managed the farmland during retirement. After the husband’s death, the surviving spouse continued to actively participate in the farm operation. The couple had owned the farmland more than ten years at the date of the husband’s death. The wife sells the farmland five years after her husband’s death.Iowa Code Section 422.7, subsection 21, provides for an Iowa capital gain deduction from net capital gain from the sale of real property used in a business, in which the taxpayer materially participated for ten years, as defined in Section 469(h) of the Internal Revenue Code, and which has been held for a minimum of ten years. Therefore, both the 10 year ownership requirement and the 10 year material participation requirement must be met to qualify for the Iowa capital gains deduction.Iowa Rule 701-40.38(1)(c)(7) sets forth requirements for material participation for retired farmers and surviving spouses of farmers, and this is noted below:“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 the farmer’s retirement or disability. That is, the farmer must have been subject to self–employment tax in five of the eight years before retirement or disability and had to have been either actively farming so the income was reported on Schedule F or materially participating in a crop–share activity for five of those eight last years prior to retirement or disability.EXAMPLE. Fred Smith was 80 years old in 1991 when he sold 200 acres of farmland he had owned since 1951. Mr. Smith retired in 1981. In the last eight years before retirement, Mr. Smith was paying self–employment tax on his farm income which was reported on Schedule F for each of those eight years. In the years before he sold the farmland, Mr. Smith was leasing the farmland on a cash–rent basis, whereby Mr. Smith would not be considered to be materially participating in the farming activity. Because Mr. Smith had material participation in the farmland in the eight years before retirement, Mr. Smith was considered to have met the material participation requirement, so the capital gain qualified for the Iowa capital gain deduction.• A surviving spouse of a farmer is treated as materially participating in the farming activity for the current tax year if the farmer met the material participation requirements at the time of death and the spouse actively participates in the farming business activity. That is, the spouse participates in the making of management decisions relating to the farming activity or arranges for others to provide services (such as repairs, plowing, and planting).”Based on the facts presented in your letter, the Department will assume that the ten year material participation requirement has been met for both the husband and the surviving spouse. The answers that follow will presume that the material participation requirement has been met.In your first example, the husband and wife owned the farmland as tenants-in-common, where each spouse is deemed to own 50% of the farmland. In this case, the surviving spouse is only entitled to the capital gain deduction on her original one-half of the farmland. The reference to “held” in Iowa Code Section 422.7(21) is to ownership, since capital gain tax laws originate with the sale of an asset, and an asset cannot be sold unless it is owned. This is supported by a decision of the Administrative Law Judge and the Director of Revenue in James E. and Linda Bell, Docket No. 00-20-1-0162. In this case, the surviving spouse only owned the one-half inherited from her husband for five years, so the ten year ownership requirement was not met.Your next question asked whether the answer would be different if the ownership had been joint tenants rather than tenants-in-common. If the ownership was joint tenancy, both the husband and wife are deemed to own 100% of the farmland. In this case, the surviving spouse would have been entitled to take the capital gain deduction on the entire farmland, since she would have met the 10 year ownership requirement.Your next questions involve similar facts, except that the husband left his ownership to a “by-pass” trust rather than directly to the surviving spouse. This leaves a situation where the trust and the surviving spouse each own an undivided one-half interest in the farmland.The Department considers any transfer of real property as an event which starts the ten year holding period and ten year material participation period for the new owner. Therefore, if the farmland was sold five years after the husband’s death, any capital gain reported by the trust, even if the proceeds were distributed to the surviving spouse, would not qualify for the capital gain deduction since the ten year ownership period and ten year material participation period was not met by the trust. Likewise, if the surviving spouse did a Section 1031 like-kind exchange with the trust to acquire 100% ownership of the acres she wanted to sell, she would not meet the ten year ownership period to qualify for the capital gain deduction.If you have any questions on this matter, please contact me at (515) 281-6183.Sincerely,Jim McNultyPolicy SectionCompliance Division