The 2018 tax code treats trade-in value as a capital gain that is taxed. The farmer can then depreciate the entire value of the new equipment, but their adjusted gross income will reflect a higher income on the Free Application for Student Aid (FAFSA).

“College aid is very much based on Adjusted Gross Income, so there are farmers that need to be aware of this,” said Paul Gorman, Ed.D., ELCEL Solutions, Mankato, Minn. A Farm Business Management educator for 20 years, Gorman has spent the last 10 years privately consulting farm families.

“I think a lot of the folks that are trading equipment must consider this if they have kids in college,” he said.

Federal IRS regulations on the treatment of farm capital purchases with equipment trade-ins have changed the way depreciation is accounted for on the Schedule F (Form 1040) Profit or Loss from Farming.

New IRS rules

The new IRS rules require that a farmer treat the trade-in of an old item as a sale that comes under capital gains. Under these rules, if a farmer purchases a tractor for $200,000, and trades in a tractor with $120,000 in remaining market value but depreciated out, the trade-in of the old tractor is considered an asset sold for $120,000. It is recognized on the tax return as capital gains income. The farmer had paid $80,000 to boot, but under the new tax law they can depreciate the tractor for $200,000. Unfortunately, farm incomes are down and many can’t use the Section 179 rapid depreciation to offset the gain problem. They could owe about $12,000 in federal taxes and maybe $6,000 in state taxes, suggested Gorman.

Old IRS rules

Under prior tax laws, the farmer purchased the $200,000 tractor and traded in their old tractor with a $120,000 remaining market value. He paid $80,000 to boot and depreciated the additional $80,000 over time. There were no capital gains on the old tractor because the remaining basis rolled to the new purchase.

In addition to the unplanned tax burden under the new rules, the farm family also has an Adjusted Gross Income (AGI) increase of over $120,000 making it difficult for a college student to receive some types of financial aid.

“This ‘phantom income’ for $120,000 that did not exist is kicking our farm family college student out of eligibility for student aid grants such as the Pell Grant,” Gorman said.

He suspects this change in IRS rules may have already caught farm families off guard, and also needs to be noted for the future. Farm families can write a letter to the financial aid office of the college their student is attending and explain why their AGI is so high, he said.

“There is nothing to be done about it, unless you know it’s coming and you are going to recognize a capital gain on your trade-in of equipment,” he said. “If you know it’s coming, and you have a child in college, then you would probably sell a little less grain in November and December and prepay more seed fertilizer and chemical in that timeframe for the next year.”

He warned that taking a Schedule F quite negative isn’t a very wise move either, because it’s difficult to explain that business strategy to lenders.

“There’s ordinary income, there’s earned income and then there are capital gains,” Gorman said. “The capital gains are added into the tax returns and that jumps the AGI income way up.”