It's never too early to plan ahead with your tax advisor to discuss some strategies.
For the 2006 tax year, you may want to examine several key items regarding deductions and capital gains, according to Gary Hoff, Extension specialist in taxation, University of Illinois Tax School.
Although there haven't been sweeping farm specific changes in this year's tax code, Hoff offers the following as notable items to discuss with your tax advisor:
“Parents helping their children save for a college education were thrown a curve ball with the Tax Increase Prevention & Reconciliation Act (TIPRA) of 2005,” says Hoff. “Enacted May 17, 2006, parts of the Act were made retroactive to Jan. 1, 2006.”
Hoff says TIPRA modified how children's savings, investment income or other interest-bearing accounts are taxed based on the child's age. Before TIPRA, children under 14 would have been taxed at their parents' highest tax rate on any investment income in excess of $1,700. TIPRA bumped up that age level to 18.
“Parents who made estimated tax payments for 2006 might find possible tax due on the children's investment income,” he says.
“I recommend exploring with your tax advisor the 529 education savings plans,” he says. “They escape the kiddie tax, but they do differ by state.”
The current capital gains tax has been extended through the end of 2010. “The key change here is the sunset date; the actual tax rates remain the same,” he says.
For example, there is still a 5% rate on capital gains and qualified dividends for taxpayers who are in a 15% tax bracket or less. For other taxpayers, the capital gains tax rate will remain at 15%.
“Compared to years ago, this rate represents a substantial savings, especially for anyone in a 25% or higher tax bracket,” he says.
Despite the rates being at all-time lows, Hoff says there continues to be a noticeable interest among farmers in Section 1031, or often called “like-kind” property exchange.
For farmers planning to sell land, pursuing a Section 1031 exchange offers a way to defer any possible capital gains taxes. However this is only a deferral. The basis of the old property transfers to the new property, and the taxes must be paid if the new property is ever sold.
“Farmers really need to think this through with their tax advisors,” says Hoff. “Like-kind property exchange rules are very detailed. For example, there are rigid time frames to meet in identifying new property and finalizing the transaction.”
Hoff strongly recommends seeking out professional tax advice well before any land sale is made. “Once you have the cash in hand from the land sale, it's considered a taxable transaction,” he says. “With capital gains at such all-time lows, you might find that it's more advantageous to pay the tax rather than to defer it.”
The Section 179 deduction for 2006 has been increased to $108,000 compared to last year's level of $105,000.
The deduction applies to tangible property like machinery and equipment, certain single-purpose agricultural structures (see IRS Farmer's Tax Guide, Publication 225), bulk storage facilities (i.e., grain bins), gasoline storage tanks, office equipment and even off-the-shelf computer software purchased for the business.
“This deduction has increased over the years because it's indexed for inflation,” says Hoff. “However, Section 179 has a sunset extension date of 2009, after which it will drop back down to the old base level of $25,000. So it's wise to maximize your deduction each year.”
Section 179 is also flexible enough in what qualifies for deductions so that you can tailor or adjust your tax liability accordingly.
In short, the deductions allowed under Section 179 offer a good way to lower your Schedule F income. For a sole proprietor, using Section 179 can also reduce your self-employment income tax, according to Hoff.
The 2006 Domestic Production Activities Deduction has been tightened up slightly for 2006.
The key change is that only W-2 wages directly involved with the “business activity” will be eligible when calculating the deduction, according to Hoff. Before, all W-2 wages paid were included.
The Internal Revenue Service (IRS) refers to it as Qualified Production Activities Income. Only W-2 wages paid out for the qualified production or activity will be considered for the deduction. You also have to be manufacturing or producing something to use the deduction.
“Farmers who operate under a calendar tax year may not be greatly impacted for 2006 since the changes and provisions of this qualified production deduction take effect for tax years beginning after May 17 of this year,” says Hoff. “It is, however, important to know about the changes as you move into 2007.”
For 2006, the production activity deduction is 3% of your “qualifying” income and is limited to 50% of the W-2 wages. In 2007, the deduction rate climbs to 6% and remains at that level for 2008 and 2009. In 2010, the deduction rate reaches a ceiling of 9%.
Also, if a separate partnership — whether a LLP or LLC — besides the main farm enterprise passes the Qualified Production Activities Income test, you may be able to capture an added deduction benefit since it will be combined with any other qualifying production income on Form 1040, according to Hoff.
This qualified pass-through income will show up on Schedule K, and the actual deduction will be claimed on the IRS Domestic Production Activities Deduction Form 8903.
Additional deductions might also apply if, for example, your spouse (as a sole proprietor filing a Schedule C) is involved with an off-farm enterprise that directly produces something for sale. Again, Hoff recommends discussing this with your tax advisor.
The Alternative Minimum Tax (AMT) exemption rates haven't changed if your AMT taxable income is $150,000 or less, Hoff says.
“More people are being snagged by the tax because the AMT brackets aren't adjusted annually for inflation,” Hoff says.
Working with your tax advisor to run the numbers on Form 6251 (AMT for Individuals) may be required to determine whether or not the AMT is owed.
Visit the University of Illinois farmdoc (Farm Decision Outreach Central) tax Web site at: www.farmdoc.uiuc.edu/legal/index.asp#taxation.
The Farmer's Tax Guide, Publication 225, IRS, is available online at: www.irs.gov/publications/p225/. The 2005 version is available online now (also in pdf form), and the 2006 version should be available soon.
The Pension Protection Act of 2006, IRS Newsletter Vol. 3, Summer 2006, can be accessed at: www.irs.gov/pub/irs-tege/rne_sum06.pdf.
Discuss this law with your tax advisor since it contains a number of significant tax incentives to enhance retirement savings.
The University of Illinois Tax School Web site: www.ace.uiuc.edu/TaxSchool/.