Wednesday, April 30, 2008

Should we sell the farm and pay the tax?

Reader's Question: Next year we will sell our family farm and expect to net in excess of $200,000. Our tax preparer says to pay the tax and invest the rest. Is this correct? If so, where should we invest? My husband and I are both in our 60s and would certainly like more income to help us enjoy this stage of our life.

Since you are selling real estate, you should first determine whether or not your farm qualifies as your principal residence; in accordance with IRS rules, if your farm property is your home, you and your husband might qualify for exclusion of up to $500,000 in profits from your capital gains tax calculation. Here's a article covering this home-sale tax exemption.

If your farm is not your principal residence, then it will likely be treated as an investment property and you can qualify for a "like-kind" 1031 tax-deferred exchange if you meet the IRS requirements. Again, here's a article for an overview. You might consider swapping your farm for any of a variety of common types of rental income property (e.g., apartments, small offices, self-storage facilities). Appropriately selected rental properties are capable of offering solid positive cash flow, which can provide the income stream you are seeking. With real estate markets weakening across the country, now seems to be a good time to start looking for properties being offered at attractive prices by motivated sellers.

As your tax preparer suggests, you can alternatively just pay any capital gains tax you might owe upon sale of your farm and roll the after-tax proceeds into other investments of your choice. If you choose to follow this option, I would suggest paying close attention to fees and expenses when reinvesting. Minimizing investment management fees will tend over time to give you higher returns. If you are comfortable choosing individual stocks (including ETFs and REITs, many of which pay substantial dividends) and bonds on your own, you'll save by avoiding having to pay fees to a fund manager. Opening an account at a reputable discount broker can also help reduce transaction costs. If you decide that mutual funds suit your investment style better than buying individual securities directly, I suggest seriously considering only funds with low fees and low portfolio turnover.

In case you have not yet seen it, you might also wish to peruse my earlier comments on wealth generation in a five-part series on long-term investing.