June 23, 2020
Iowa has a unique state tax break for a limited set of capital gains. Certain sales of businesses or business real estate are excluded from Iowa taxation, but only if they meet two stiff tests:
1. The real estate has to have been held for ten years, and
2. The taxpayer must demonstrate "material participation" in the business for the ten years prior to the sale.
A northeast Iowa Couple failed to convince the Iowa Supreme Court that a sale of cash rental of farmland qualified for the break. The ten year holding period wasn't a problem. Participation? That was a problem.
Both the "holding" and "participation" tests are based on federal tax rules. The participation tests are based on the material participation tests under the federal Section 469 passive loss rules, with some Iowa-only twists.
One twist is that "material participation" is easier to achieve in Iowa in real estate rental businesses. While federal rules limit material participation in real estate rental to real estate professionals (including a 750-hour participation test), Iowa doesn't. That enables a part-time landlord to qualify for the exclusion in many cases where they fall short of material participation.
But farm landlords? The Iowa Supreme Court didn't buy it:
The evidence presented in this case reveals the limited involvement of a typical cash-rent farm landlord. Rent payments were made only twice per year, as is typical in a cash-rent farm lease. The only thing changed on the standard farm lease form from year to year was the per-acre rate, requiring at most a two-hour renegotiation, and even that did not always change. The standard lease form placed on the tenant the obligations “to keep said premises free from brush and burrs, thistles, and all noxious weeds, and [to] mow and cut near the surface of all weeds.” Given the focus of a farm lease on the land rather than any incidental buildings, those terms leave little else for a cash-rent farm landlord to do.
The court held that this Iowa administrative rule was valid and applied:
Cash farm lease. A farmer who rents farmland on a cash basis will not generally be considered to be materially participating in the farming activity. The burden is on the landlord to show there was material participation in the cash-rent farm activity.
The taxpayers argued that the Iowa statute did not distinguish between farm leases and other commercial leases, but the Iowa court said that the distinction was a valid administrative interpretation. The court found that the taxpayers failed to meet their burden of demonstrating material participation:
Their limited activities of collecting rent twice a year and renegotiating the leases, a two-hour endeavor, were not “regular, continuous, and substantial.”
Decision for the Department of Revenue.
The Moral? It's hard for cash-rent taxpayers to meet Iowa's material participation rules. Farm landlords will need to carefully document their participation to have any chance of prevailing. Still, Iowa generally permit the gain exclusion farmers in "self-rental" situations, where a farmer rents to his farm corporation.
The decision may also be bad news for non-farm landlords who rent to their business. The Department of Revenue has held that self-rental by landlords of commercial property to a non-farm business cannot use participation in the business to determine whether they participate in the rental activity - a different rule than the Department applies to farmland self-rentals. The deference shown to Department rules in this decision makes it more likely that the Iowa courts will respect that distinction.
Cite: Iowa Supreme Court, No. 19–0261 (June 19, 2020)
Iowa Capital Gain Deduction - Iowa Department of Revenue
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