Special use valuation eases the pain of land inflation

May 21, 2010
by DTN

Although the federal estate tax law is currently in congressional limbo, it’s still important to plan for your farm’s succession. For those who die in 2010, Congress has eliminated the federal estate tax—just for one year. For those of us who have the good fortune of living past that, the law reverts to a graduated rate from 41 percent on estates over $1 million, increasing to 55 percent for estates over $10 million beginning on Jan. 1, 2011.

Most estate tax lawyers had expected Congress to act before the end of this year to raise that exemption back to $3.5 million (which it was in 2009), but that may not happen.

In the meantime, the general consensus among estate planners is farm owners should reduce the size of taxable estates, so their families do not have to give almost half of that estate to the government. In states that have their own inheritance or estate tax, reducing estate size is especially important to save taxes. “This is particularly true in Minnesota, which has just a $1 million exemption for the state estate tax,” explains Evy Olson, with Larson Allen CPAs and Advisors in New Ulm, MN.

Don’t overlook land discounts Besides gifting, larger farm estates with heirs who want to continue farming can use a special provision that allows farmland to be valued according to its productivity, not its fair market value. This “special use” valuation can slash the value of an estate by up to $1 million.

David Bibler, an agricultural attorney in Algona, IA, gives this example: Take a farm with a fair market value of $5,000 per acre. Over the past five years, the average cash rent on this farm (taking out the top and the low years) was $220 per acre, minus $20 per acre property tax, for a net of $200 per acre. Let’s say the Farm Credit Service mortgage interest rate is 6.5 percent. Take the $200 net return, divided by that interest rate, and the productive value of the farm is $3,077 per acre. That is the value you can use for “special use” when calculating estate tax. In this example, you’ve reduced the value of each acre by $1,923, or by about 40 percent. Since the reduction in value cannot exceed $1 million, you could use the discount only on 520 acres.

“This provision is very useful if it applies to you, but in the past four or five years, as the estate tax exemption has risen to $3.5 million (in 2009), it has become less applicable in rural Iowa,” says Bibler.

Roger McEowen, agricultural economist and tax expert with Iowa State University, thinks the terms remain valuable, “especially if your estate is in the $3.5 million-to-$5 million range.” What’s more, no one knows for sure what size estates will pass tax-free until Congress revisits the law.

How to qualify

Strict eligibility requirements can limit special use’s application. Mainly, the person who owns the land should be farming the land when he or she dies. If that person is leasing out the farm at death, the land can be cash rented to his or her child or a child of an heir. Leased to anyone else, however, it must be on a cropshare basis. The other more burdensome requirement for many families is the heir must farm it for another 10 years after the owner dies.

“The problem with that is parents are living longer,” says Bibler. “When a person dies at 85 or 90 years old, their child is 65 and now has to farm another 10 years to keep the ‘special use’ valuation. They can custom farm it or share crop lease it for 10 years, but then they have to pay social security tax on their income and be at risk on production and price for the crop on the farm.” McEowen explains a flexible cash lease will qualify.

Another limit: For 10 years after death, the farm that elected “special use” cannot be sold or there is recapture of the tax on the portion of the farm that is sold.

One trade-off for having a reduced value at death and estate tax savings is farmers reduce the tax basis on the land to its special use value. So, if they want to sell the farm after farming it for 10 years, they would pay a capital gains tax based on the profit above the special use value, not the fair market value at death. In the example, instead of having a $5,000-per-acre tax basis when the farmer sold the land, it would have a tax basis of $3,077 per acre. However, a future capital gains tax could likely be less than the at-death estate tax rate.

To keep the option open for his farm clients, Bibler files a “protective special use” election when he files the estate tax. “That means we may want to use special use valuation on this tax return. If we are bumping up against the exemption and IRS thinks the value of the estate is higher than we do, we can go back and apply ‘special use’ on a portion of the land,” Bibler explains. The particular tract does not have to be specified until the special use election is made.

Too late to save some land

For farmers in rural areas that need an extra $1 million exemption from estate tax to keep the family farm together, the current “special use” rules work, but for those farmers bumping up against major metropolitan areas or vacation destinations, the special use exemption is woefully inadequate.

Farms as small as 40 acres can bring a $25 million price tag in beach resort areas, notes John v.H. Halsey with the Peconic Land Trust on Long Island, NY. Forced sale of farms to pay estate taxes is a common occurrence there, he says. Halsey’s group would like to make environmentally sound, qualified farmland or land of conservation value exempt from federal estate tax, without a limit as long as the land stays in farming or conservation use.

“It would be a voluntary election. A recapture tax penalty would be binding on any successive owners who take the land out of agriculture or its conservation use,” Halsey says. This would transform federal estate tax policy to a land-based incentive program for conservation. So far, however, Congress hasn’t warmed up to any estate tax reforms, so most farm families must navigate based on hunches. — Elizabeth Williams, DTN