Kentucky Department of Agriculture

Many farmers choose to replace their cull cows by raising heifers from their herd. Another method that farmers may want to consider is to sell their heifers as market calves and purchase replacement heifers, bred to calve the following year. The purpose of this article is to walk through the tax implications of both alternatives.

The cost basis of purchasing heifers is the purchase cost, which is a depreciable expense over a five-year life. Under the current tax regulations, you can choose to use tax code Section 179 to expense the heifer in the year she was purchased. Raised heifers have no cost basis and therefore cannot be depreciated. However, you are able to deduct the cost of raising and developing her (feed, medicine, vet, breeding, etc.) as those expenses occur. If you purchase heifers, your depreciable expense may be partially offset by the income you receive from selling the raised heifers at weaning.

The gain on the sale of raised breeding livestock is usually the gross sale price minus any expenses from the sale (sales commission, freight, or hauling). On the other hand, the gain on the sale of purchased breeding livestock is the gross sales price minus your adjusted basis and any sale expenses. For example, a farmer sold a raised breeding cow for $1,500 and had $150 sales commission fee. The realized gain on that sale would be $1,350. Now use the same scenario as above, but the cow was purchased for $1,850 and depreciation allowed was $950. In this case, the realized gain is $450 (gross sales - purchase cost + depreciation allowed - sales fees).

Capital Gains vs. Ordinary Gains: There is an important distinction between capital gains and ordinary gains, and in the case of selling breeding stock, gains can be either, or some of both, depending on the situation. If purchased cattle are sold for less than the purchase price, all gains are also considered ordinary income. Gains on purchased cattle sold for more than the purchase price are considered both ordinary and capital. The difference between the gross sale and the purchase price is considered to be capital gains, while the remaining part of the gain is considered to be ordinary income.

Capital gains are currently taxed at a maximum rate of 15 percent, while ordinary gains are taxed at the marginal rate of the income tax bracket the taxpayer falls in. In many instances a farmer’s taxable income will be above the 15 percent tax bracket, so capital gains are usually preferred. In order to be considered for capital gains, cattle (raised or purchased) must be held for at least 24 months. If cattle (raised or purchased) are held for less than 24 months, the gain is considered ordinary and taxed accordingly. All gains on a sale of raised cattle held more than 24 months are considered capital gains and taxed at a maximum of 15 percent. Long-term capital gains rates vary from 0-15 percent based on the taxpayer’s ordinary tax rate on all taxable income. For 2012, capital gains rates are 0 percent for taxpayers in the 10 percent and 15 percent tax bracket and 15 percent for any taxpayer in the 25 percent bracket or above. The brackets are set to change for 2013, so you may want to consult your tax professional about this.

The following are four examples intended to make this distinction more clear:

Example 1: A farmer sold a cow for $2,500 that was purchased two years earlier for $1,500 and depreciation allowed was $800. The adjusted basis in the cow is $700 ($1,500-$800). The total gain on the sale is $1,800 ($2,500-$700). One thousand dollars is considered to be capital gains and taxed at the capital gains rate ($2,500-$1,500), while the remaining $800 is considered ordinary gains and is taxed at the corresponding tax bracket.

Example 2: The same cow was sold as in example one, but this time the cow had been completely depreciated out so the adjusted basis is $0. In this example, the total gains would be $2,500 with $1,000 still being considered as capital gains, while the other $1,500 are considered ordinary income.

Example 3: Now let’s assume the same situation as in example 2, but the farmer sold the cow for only $700. In this example, the total gains would be $700, and all of it would be ordinary income.

Example 4: The same farmer sold another cow that had been held for more than two years for $2,500, but this cow was raised. As in example 2, the total gains are $2,500, but in this example all the gains are considered capital gains and taxed at a maximum of 15 percent.

It is important that you talk to your tax professional and that you provide him/her with accurate information. Cull cattle sales should be kept separate from calf sales, and raised cattle sales should be kept separate from purchased.Cull cows should be identified on the depreciation schedule and given to the tax professional. For additional tax information, IRS Publication 225 (Farmer’s Tax Guide) is an excellent resource.

This article was written by Michael Forsythe, an agricultural economists in the University of Kentucky College of Agriculture. The article first appeared in the June 20 edition of Economic and Policy Update.