Iowa Administrative Code › Agency 701 - Revenue Department › Title I - Administration › Chapter 40 - Determination of Net Income › Rule 701-40.38 - Capital Gain Deduction or Exclusion for Certain Types of Net Capital Gains

Current through Register Vol. 47, No. 3, July 24, 2024
For tax years beginning on or after January 1, 1998, net
				  capital gains from the sale of the assets of a business described in subrules
				  40.38(2) to 40.38(8) are excluded in the computation of net income for
				  qualified individual taxpayers. This includes net capital gains from the sales
				  of real property, sales of assets of a business entity, sales of certain
				  livestock of a business, sales of timber, liquidation of assets of certain
				  corporations, and certain stock sales which are treated as acquisition of
				  assets of a corporation. "Net capital gains" means capital gains net of capital
				  losses because Iowa's starting point for computing net income is federal
				  adjusted gross income. A business includes any activity engaged in by a person
				  or caused to be engaged in by a person with the object of gain, benefit, or
				  advantage, either direct or indirect. Subrule 40.38(1) describes the criteria
				  for material participation which are required for the exclusion of certain
				  capital gains related to the sale of real property and the sale of assets of
				  business entities. Subrule 40.38(9) describes situations in which the capital
				  gain deduction otherwise allowed is not allowed for purposes of computation of
				  a net operating loss or for computation of the taxable income for a tax year to
				  which a net operating loss is carried.
(1)
Material participation in a
				business if the taxpayer has been involved in the operation of the business on
				a regular, continuous, and substantial basis for ten or more years at the time
				assets of the business are sold or exchanged.
If the taxpayer has
				regular, continuous and substantial involvement in the operations of a business
				which meets the criteria for material participation in an activity under
				Section 469(h) of the Internal Revenue Code and the federal tax regulations for
				material participation in 26 CFR §1.469-5 and § 1.469-5T, for the ten
				years prior to the date of the sale or exchange of the assets of a business,
				the taxpayer shall be considered to have satisfied the material participation
				requirement for this subrule. In determining whether a particular taxpayer has
				material participation in a business, participation of the taxpayer's spouse in
				a business must also be taken into account. The spouse's participation in the
				business must be taken into account even if the spouse does not file a joint
				state return with the taxpayer or if the spouse has no ownership interest in
				the business. The activities of other family members, employees, or consultants
				are not attributed to the taxpayer to determine material participation.
a. Work done in connection with an activity
				shall not be treated as participation in the activity if such work is not of a
				type that is customarily done by an owner and one of the principal purposes for
				the performance of such work is to avoid the disallowance of any loss or credit
				from such activity.
b. Work done in
				an activity by an individual in the individual's capacity as an investor is not
				considered to be material participation in the business or activity unless the
				investor is directly involved in the day-to-day management or operations of the
				activity or business. Investor-type activities include the study and review of
				financial statements or reports on operations of the activity, preparing or
				compiling summaries or analyses of finances or operations of the activity for
				the individual's own use, and monitoring the finances or operations of the
				activity in a nonmanagerial capacity.
c. A taxpayer is most likely to have material
				participation in a business if that business is the taxpayer's principal
				business. However, for purposes of this subrule, it is possible for a taxpayer
				to have had material participation in more than one business in a tax
				year.
d. A highly relevant factor
				in material participation in a business is how regularly the taxpayer is
				present at the place where the principal operations of a business are
				conducted. In addition, a taxpayer is likely to have material participation in
				a business if the taxpayer performs all functions of the business. The fact
				that the taxpayer utilizes employees or contracts for services to perform daily
				functions in a business will not prevent the taxpayer from qualifying as
				materially participating in the business, but the services will not be
				attributed to the taxpayer.
e.
				Generally, an individual will be considered as materially participating in a
				tax year if the taxpayer satisfies or meets any of the following tests:
(1) The individual participates in the
				business for more than 500 hours in the taxable year.
Example. Joe and Sam Smith are brothers who formed a
				  computer software business in 2001 in Altoona, Iowa. In 2011, Joe spent
				  approximately 550 hours selling software for the business and Sam spent about
				  600 hours developing new software programs for the business. Both Joe and Sam
				  would be considered to have materially participated in the computer software
				  business in 2011.
(2) The
				individual's participation in the business constitutes substantially all of the
				participation of all individuals in the business for the tax year.
Example. Roger McKee is a teacher in a small town in
				  southwest Iowa. He owns a truck with a snowplow blade. He contracts with some
				  of his neighbors to plow driveways. He maintains and drives the truck. In the
				  winter of 2011, there was little snow so Mr. McKee spent only 20 hours in 2011
				  clearing driveways. Roger McKee is deemed to have materially participated in
				  the snowplowing business in 2011.
(3) The individual participates in the
				business for more than 100 hours in the tax year, and no other individual
				spends more time in the business activity than the taxpayer.
(4) The individual participates in two or
				more businesses, excluding rental businesses, in the tax year and participates
				for more than 500 hours in all of the businesses and more than 100 hours in
				each of the businesses, and the participation is not material participation
				within the meaning of one of the tests in subparagraphs
				40.38(1)
"e"
(1) to (3) and (5) to (7). Thus, the taxpayer is
				regarded as materially participating in each of the businesses.
Example. Frank Evans is a full-time CPA. He owns a restaurant
				  and a record store. In 2011, Mr. Evans spent 400 hours working at the
				  restaurant and 150 hours at the record store and other individuals spent more
				  time in the business activity than he did. Mr. Evans is treated as a material
				  participant in each of the businesses in 2011.
(5) An individual who has materially
				participated (determined with regard to subparagraphs 40.38(1)
"e
				"
(1) to (4)) in a business for five of the past ten years will be
				deemed a material participant in the current year.
Example. Joe Bernard is the co-owner of a plumbing business.
				  He retired in 2008 after 35 years in the business. Since Joe's retirement, he
				  has retained his interest in the business. Joe is considered to be materially
				  participating in the business for the years through 2013 or for the five years
				  after the year of retirement. Thus, if the plumbing business is sold before the
				  end of 2013, the sale will qualify for the Iowa capital gain deduction on Joe's
				  2013 Iowa return because he was considered to be a material participant in the
				  business according to the federal rules for material participation.
(6) An individual who has
				materially participated in a personal service activity for at least three years
				will be treated as a material participant for life. A personal service activity
				involves the performance of personal services in the fields of health, law,
				engineering, architecture, accounting, actuarial science, performing arts,
				consulting or any other trade or business in which capital is not a material
				income-producing factor.
Example. Gerald Williams is a retired attorney, but he
				  retains an interest in the law firm he was involved in for over 40 years.
				  Because the law firm is a personal service activity, Mr. Williams is considered
				  to be a material participant in the law firm even after his retirement from the
				  firm.
(7) An individual who
				participates in the business activity for more than 100 hours may be treated as
				materially participating in the activity if, based on all the facts and
				circumstances, the individual participates on a regular, continuous, and
				substantial basis. Management activities of a taxpayer are not considered for
				purposes of determining if there was material participation if either of the
				following applies: any person other than the taxpayer is compensated for
				management services, or any person provides more hours of management services
				than the taxpayer.
f.
				The following paragraphs provide clarification regarding material
				participation:
(1) A retired or disabled
				farmer is treated as materially participating in a farming activity for the
				current year if the farmer materially participated in the activity for five of
				the last eight years before the farmer's retirement or disability. That is, the
				farmer must have been subject to self-employment tax in five of the eight years
				before retirement or disability and had to have been either actively farming so
				the income was reported on Schedule F or materially participating in a
				crop-share activity for five of the last eight years prior to retirement or
				disability. The farmer must be receiving old-age benefits under Title II of the
				Social Security Act to be considered a retired farmer.
Example. Fred Smith was 80 years old in 2011 when he sold 200
				  acres of farmland he had owned since 1951. Mr. Smith retired in 2001 when he
				  began receiving old-age benefits under Title II of the Social Security Act. In
				  the last eight years before retirement, Mr. Smith was paying self-employment
				  tax on his farm income which was reported on Schedule F for each of those eight
				  years. In the years before he sold the farmland, Mr. Smith was leasing the
				  farmland on a cash-rent basis, whereby Mr. Smith would not be considered to be
				  materially participating in the farming activity. Because Mr. Smith had
				  material participation in the farmland in the eight years before retirement,
				  Mr. Smith was considered to have met the material participation requirement, so
				  the capital gain qualified for the Iowa capital gain deduction.
(2) A surviving spouse of a farmer
				is treated as materially participating in the farming activity for the current
				tax year if the farmer met the material participation requirements at the time
				of death and the spouse actively participates in the farming business activity.
				That is, the spouse participates in the making of management decisions relating
				to the farming activity or arranges for others to provide services (such as
				repairs, plowing, and planting). However, if the surviving spouse was retired
				at the time of the farmer's death and the deceased spouse materially
				participated in the farming activity for five of the last eight years prior to
				the deceased spouse's retirement, then the surviving spouse is deemed to be
				materially participating, even if the surviving spouse did not actively
				participate in the farming activity. See IRS Technical Service Memorandum
				200911009, March 13, 2009.
(3)
				Limited partners of a limited partnership. The limited partners will not be
				treated as materially participating in any activity of a limited partnership
				except in a situation where the limited partner would be treated as materially
				participating under the material participation tests in subparagraphs
				40.38(1)
"e "
(1), (5) and (6) above as if the taxpayer were not
				a limited partner for the tax year.
(4) 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.
(5) Farm landlord involved in crop-share
				arrangement. A farm landlord is subject to self-employment tax on net income
				from a crop-share arrangement with a tenant. The landlord is considered to be
				materially participating with the tenant in the crop-share activity if the
				landlord meets one of the four following tests:
Test 1. The landlord does any three of the following:
(1) Pays or is obligated to pay
				for at least half the direct costs of producing the crop;
(2) Furnishes at least half the tools,
				equipment, and livestock used in producing the crop;
(3) Consults with the tenant; and
(4) Inspects the production activities
				periodically.
TEST 2. The landlord regularly and frequently makes, or takes
				  part in making, management decisions substantially contributing to or affecting
				  the success of the enterprise.
Test 3. The landlord worked 100 hours or more spread over a
				  period of five weeks or more in activities connected with crop
				  production.
Test 4. The landlord has done tasks or performed duties
				  which, considered in their total effect, show that the landlord was materially
				  and significantly involved in the production of the farm commodities.
(6) Conservation reserve payments
				(CRP). Farmers entering into long-term contracts providing for less intensive
				use of highly erodible or other specified cropland can receive compensation for
				conversion of such land in the form of an "annualized rental payment." Although
				the CRP payments are referred to as "rental payments," the payments are
				considered to be receipts from farm operations and not rental payments from
				real estate.
If an individual is receiving CRP payments and is not
				  considered to be retired from farming, the CRP payments are subject to
				  self-employment tax. If individuals actively manage farmland placed in the CRP
				  program by directly participating in seeding, mowing, and planting the farmland
				  or by overseeing these activities and the individual is paying self-employment
				  tax, the owner will be considered to have had material participation in the
				  farming activity.
(7)
				Rental activities or businesses. For purposes of subrules 40.38(1) and
				40.38(2), the general rule is that a taxpayer may have material participation
				in the rental activity unless covered by a specific exception in this subrule
				(for example, the exceptions for farm rental activities in subparagraphs
				40.38(1)
"f"
(4), (5) and (6)). Rental activity or rental
				business is as the term is used in Section 469(c) of the Internal Revenue Code.
				Rental activity or rental business does not typically involve day-to-day
				involvement since gross income from this activity represents amounts paid
				mainly for the use of the property. Examples of qualifying involvement in
				operations of the property that are considered material participation
				activities if performed on a regular, continuous and substantial basis include
				advertising, interviewing potential tenants, preparing leases, collecting rent,
				handling security deposits, receiving questions and complaints from tenants,
				and performing routine maintenance.
EXAMPLE. Ryan Stanley is an attorney who has owned two duplex
				  units since 1998 and has received rental income from these duplexes since 1998.
				  Mr. Stanley is responsible for the maintenance of the duplexes and may hire
				  other individuals to perform repairs and other upkeep on the duplexes. However,
				  no person spends more time in operating, managing and maintaining the duplexes
				  than Mr. Stanley, and Mr. Stanley spends more than 100 hours per year in
				  operating, managing and maintaining the duplexes. The duplexes are sold in
				  2011, resulting in a capital gain. Mr. Stanley can claim the capital gain
				  deduction on the 2011 Iowa return since he met the material participation
				  requirements for this rental activity.
(8) Like-kind exchanges and involuntary
				conversions. Material participation can be tacked on in cases of replacement
				property acquired under a like-kind exchange under Section 1031 of the Internal
				Revenue Code or an involuntary conversion under Section 1033 of the Internal
				Revenue Code.
EXAMPLE. Dustin James owned Farm A, and he materially
				  participated in the operation of Farm A for 10 years. Mr. James executed a
				  like-kind exchange for Farm B, and he materially participated in the operation
				  of this farm for 4 years until he retired. Mr. James sold Farm B 2 years after
				  he retired. Although he only materially participated in the operation of Farm B
				  for 4 of the last 8 years before he retired, the operation of Farm A can be
				  tacked on for purposes of the material participation test. Mr. James meets the
				  material participation test since he participated in farming activity for the
				  last 14 years before he retired.
(9) Record-keeping requirements. Taxpayers
				are required to provide proof of services performed and the hours attributable
				to those services. Detailed records should be maintained by the taxpayer, on as
				close to a daily basis as possible at or near the time of the performance of
				the activity, to verify that the material participation test has been met.
				However, material participation can be established by any other reasonable
				means, such as approximating the number of hours based on appointment books,
				calendars, or narrative summaries. Records prepared long after the activity, in
				preparation of an audit or proceeding, are insufficient to establish
				participation in an activity.