With depressed prices decreasing profits, many older dairy producers are contemplating retirement. These producers have probably planned on selling their farms to raise the money needed to cover their living expenses during retirement.

While selling the farm would seem the most logical route, it may be more profitable for some producers to hold on to their farms. Keeping the land avoids capital gains taxes and retains an asset that is increasing in value.

Retiring farmers who sell land typically have to pay taxes at a rate of 20 percent on any capital gains they realize on the sale of their farms. For example, if a producer purchased his farm for $140,000, and the current market value is $240,000, the producer would have to pay a tax of 20 percent on the difference, or $20,000 in taxes. ($240,000 - $140,000 = $100,000 x 0.20 = $20,000.)

Rather than letting the government get a piece of their hard-earned wealth, dairy producers do have some options, such as holding onto the farm at retirement and renting out the land. Historically, cash rents run at around 5 percent of the market value of farm land. While this rent equals the rate of return you could expect from a savings instrument, it is well below the average return of 10 percent or more that mutual funds and selected stocks have been yielding. However, cash rent is not the only return retired farmers could earn if they keep ownership of their farms. Additional return is earned from increasing land values. Historically, farm real estate has gained in value by around 3 percent to 4 percent per year. Together, the cash rent and rising land value equate to an annual return of roughly 9 percent per year, making it competitive with other investments.

While real estate capital gains do provide income, it is not in the form of cash, which retired producers need to pay bills. However, you can borrow against the increase in the value of the real estate — the capital gains — to get cash.

The chart on page 8 compares two courses of action. First, the farmer sells the farm and receives $220,000 after capital gains taxes. This money is invested in an annuity generating 9 percent interest. As with most estate planning, it is assumed that the farmer will survive for 20 years, so an annual income of $22,110.30 is taken, depleting the fund.

Or, the farmer can retain ownership of the land and receive a cash rent payment each year that is equal to 5 percent of the market value of the farm. The rent would increase each year as the value of land increased at a rate of 4 percent per year. To generate more cash flow, the producer could borrow the money needed to pay bills — equal to the $22,110.30 generated by the annuity-invested money.

Equity funds retirement
In this scenario, the equity of the farmer is the difference between the land value and the loan balance.

The key values presented in the table are the land equity and retirement account balances reported for year 15. The equity of the farmer who retained ownership of the land is roughly $120,000, while the retirement account balance for the farmer who sold the farm at retirement is almost $94,000. This difference of nearly $26,000 in the farmer’s land equity position and the retirement account balance represents the financial gain the farmer experiences as a result of holding onto the farm.

Farmers need to recognize that they can borrow against their farms and gain access to the equity built up in their land without having to sell the land. Borrowing against the value of the land is no different than making withdrawals from an investment account that will eventually be drawn down to a zero balance. In either of these cases, equity is used to fund retirement.

And, retaining ownership of the farm allows farmers to continue to capture the appreciation in real estate values. Second, and more importantly, it lets farmers keep tax dollars that would otherwise go to Uncle Sam as captial gains taxes.

Bruce Jones is a farm management specialist at the University of Wisconsin