Livestock, particularly breeding livestock, are among the first things usually transferred from parents to children. If you hold breeding livestock more than 1 year (more than 2 years for horses, cattle, or poultry) and use it in your trade or business, the gain or loss from its sale qualifies for capital gains treatment.
The same rule applies to livestock sales that applies to most other assets. The difference between the selling price and the property's "income tax basis" is taxable income. The difference here is that with raised livestock the basis is zero. Thus, the total sales price is taxable income. The basis is zero because all the costs associated with raising the livestock were tax-deductible expenses in the year incurred.
The "zero basis" is also important for livestock transferred by gift. As discussed in the section on gifts, the "fair market value" of the livestock determines the value of the gift for gift tax purposes. However, the person receiving the gift gets the donor's basis (zero). Thus, when the person who received the livestock sells them, the sales value is taxable income.
The tax treatments of purchased market livestock and purchased breeding livestock are slightly different. Purchased breeding stock are eligible for depreciation. Market livestock aren't depreciable and don't qualify for capital gains.
Let's look at purchased breeding stock first, using a simplified example. Assume that a farmer bought a 2-year-old heifer for $1,000. Two and one-half years later the farmer sells it to a daughter for $750. Does the farmer have a gain or loss? How much? First, even if a loss occurs, a person cannot deduct a loss on a sale to a related party.
Does the farmer have a gain? That depends on the amount of depreciation. Under current law the farmer could have taken from $214 up to $1,000 in depreciation on the cow. If the farmer took $214 depreciation, there is a small loss that cannot be claimed. If the farmer took more than $250 in depreciation (basis less than $750), the gain would equal the difference between the cow's basis and the sales price.
What if the farmer had never depreciated the cow? Depreciation is "allowed or allowable," meaning that the IRS assumes depreciation is taken even if it isn't. The farmer may not deduct the unclaimed depreciation in the current year or any later tax year. The farmer could file amended returns, claim the depreciation, and possibly benefit from depreciation not taken. An amended return must be filed within 3 years of the date of filing the original return, or within 2 years of the time the tax was paid, whichever is later. That would not eliminate the gain, but it would reduce taxable income in previous years and possibly generate a refund.
Purchased market livestock have a basis equal to their cost. Deduct this "cost basis" on the tax return in the year the animals are sold. The costs associated with raising the market livestock are deductible in the year incurred and do not increase or decrease the livestock's basis. Figure gain by subtracting basis from sales price. The difference is taxable income or loss. Losses are not allowed on sales between related parties.