People who own farmland and rent it out may soon be assessed a surtax to help pay for the federal health care overhaul. It depends on how the lease is written and their overall income levels, says Roger McEowen, professor of ag law at Iowa State University. He is also the director of the Center For Agricultural Law & Taxation at ISU in Ames. The provision, part of the measure often referred to as Obamacare, requires a 3.8% Medicare surtax on "unearned" income. This rule is scheduled to go into effect Jan. 1, 2013.
The surtax expands the definition of unearned income to include rents, royalties and other passive activities. "This could end up affecting a lot of cash rental agreements in Iowa," says McEowen. "You should visit with your tax professional regarding this, now." About 57% of Iowa's farmland is rented, a lot of landowners who could be affected.
Farmland rent income may be subject to new health care surtax
Medicare actually has two surtaxes. One is a 0.9% increase on wage income. We don't address that tax here. The other is a 3.8% surtax on passive income. "From a farm standpoint, we're concerned about cash rental arrangements by landowners retired from farming and who are no longer materially participating in the farm business," McEowen adds. "That person will be construed by IRS under the new definition of investment income as potentially subject to this 3.8% surtax."
The tax applies to married taxpayers filing jointly with modified adjusted gross income of more than $250,000 or to single taxpayers with adjusted gross incomes of more than $200,000. This is especially important to landowners who have other income, such as from an annuity or a stock sale, which could push them over the limit for paying the additional 3.8% surtax. The new surtax will not apply to taxpayers who are "materially participating" in the farming operation. This may prompt some landowners to consider revising rental agreements they have with tenants.
Landlord's "material participation" in farm operation is key
For many landowners determining whether they owe the new surtax will depend on IRS interpretation of their material participation in the farming operation. Some owners may find it advantageous to switch to a crop-share arrangement with tenants instead of using a cash rent lease. That would mean the landowner takes possession of a portion of the crop, markets it and has more participation.
What about flexible cash rent leases -- often called flex leases? That's another question to ask your tax adviser.
This material participation question will be handled case-by-case, subject to IRS interpretation. The new 3.8% Medicare surtax will also be in effect for farmland sales made after Jan. 1, 2013. Again, the tax on land sales will apply primarily to landowners who are not materially participating in the farming operation. Landowners who are actively participating in the management of the farm are likely to be exempt.
Should you switch from cash rent lease to crop share lease?
Another hitch: If you use a crop-share lease and materially participate, you can likely avoid the 3.8% surtax but then you run the risk of having to pay self-employment tax. "That's why many landowners in recent years have shifted from crop share to cash rent leases -- to avoid paying the SE tax," says McEowen. "Now we have another tax to try to avoid, if you are a passive investor. So, yes, on one hand you have a problem and on the other hand you have a problem."
It's kind of like pick your poison, which way do you want to go? Best advice is to see your tax adviser. "Every situation is unique," says McEowen. "It depends on many things such as the SE tax computation if you switch your lease; and there aren't tax regulations in place to define material participation for purposes of determining who can avoid the 3.8% surtax. What is passive? If I recently retired from farming and I now rent out my land, am I considered passive? How long of a look back will we have? What will the government allow?"
Consult with your tax adviser and beware of self-employment tax
IRS has announced they intend to issue an explanation of this Medicare surtax soon. That should help so folks can see what the regulations are. "People need to meet with their tax adviser and do a projection for 2013 and see whether they think they'll be hit by this 3.8% surtax," says McEowen. "If so they need to think about changing the lease; possibly a crop-share lease would work. But then they can run into possible self-employment tax considerations. It gets real complicated, real fast. Talk to your tax adviser now to see if you need to make a change in your farm lease."
If you have questions or want to learn more about this tax issue and related topics, go to the homepage of the Iowa Center For Agricultural Law & Taxation at www.calt.iastate.edu/
For farm management information and analysis go to ISU's Ag Decision Maker site www.extension.iastate.edu/agdm and Extension farm management specialist Steve Johnson's site www.extension.iastate.edu/polk/farm-management.