Inflated land values have increased the impact of the federal estate tax on heirs of family farm operations. In an effort to alleviate the added tax burden, Congress included a special provision for farmland valuation for federal estate tax purposes in the Tax Reform Act of 1976. This publication explains the current use provision and presents the changes made by the Economic Recovery Tax Act of 1981.Reviewed October 1, 1993

Banning, John C.

Matthews, Stephen F.

Plain, Ronald L.

University of Missouri: MOspace

  University Extension, University of Missouri-Columbia  G00505, Reviewed October 1, 1993  Farmland Valuation for Estate Tax Purposes Stephen F. Matthews, Ronald L. Plain and John C. Banning Department of Agricultural Economics, University of Missouri-Columbia Inflated land values have increased the impact of the federal estate tax on heirs of family farm operations. In an effort to alleviate the added tax burden, Congress included a special provision for farmland valuation for federal estate tax purposes in the Tax Reform Act of 1976. This publication explains the current use provision and presents the changes made by the Economic Recovery Tax Act of 1981.  When someone dies, an estate tax is levied on any property left to individuals besides the surviving spouse. The amount of the estate tax is based upon the fair market value of the property on either the date of death or six months later. A new provision in the tax law provides an alternative valuation method, which can sometimes be used by farmers to greatly reduce estate taxes.  Between 1961 and 1981, the average market value per acre of Missouri farm real estate increased more than seven times (see Table 1).  Table 1. Average dollar value per acre of Missouri farmland.  1961 $120 1962 127 1963 132 1964 145 1965 155 1966 168 1967 186 1968 200 1969 217 1970 224 1971 236 1972 261 1973 294 1974 384 1975 396 1976 456 1977 548 1978 641 1979 726 1980 878 1981 941 Source: MU publication G00406, Estimating Past Farm Real Estate Values with Limited Information (no longer in circulation).  These inflated land values can be serious obstacles to the farmer who wants to pass his business on to his family. This publication explains a major change in the federal estate tax laws for valuing farmland. This change may reduce the otherwise high federal estate tax caused by increasing land values.  Congress approved a provision in the 1976 Tax Reform Act that allows qualifying farmland to be valued on the basis of its current use for farming rather than the usual market value (highest and best use). The Economic Recovery Tax Act of 1981 loosened the qualifying conditions, making the election of current use valuation easier and more desirable.  The provision's main purpose is to reduce the likelihood that farm estate heirs will be forced to sell a portion or all of the farm to pay federal estate taxes. A lower estate valuation and a smaller taxable estate will result from using the current use valuation.     G505 1 10/1993Archive version -- Se xtension.missouri.edYear of death Five-year moving average (%) The new valuation has the potential to reduce the gross estate's value by up to $700,000 for 1982 and $750,000 after 1982.  If you own farmland and plan to pass it on to your sons, daughters or other family members, this provision could be of major importance to you. Now is the time to start planning to be sure your farm can qualify.  Qualifying conditions. To take advantage of the current use valuation, all of these eligibility requirements must be met:  • The decedent must have been a U.S. resident or a U.S. citizen, and the property must be located in the United States. • The property must pass to a qualified heir (definitions follow). • An agreement signed by the heir(s) to abide by the stipulations of Section 2032A must be filed by the executor. • The decedent or a member of the family must have owned the farm and must have materially participated in the operation of the business in five of the eight years preceding the earliest of the following: (a) the date of the decedent's death, (b) the date the decedent retired, or (c) the date the decedent became disabled. • At least 50 percent of the adjusted value of the gross estate must consist of the value of the farmland and farm personal property. • At least 25 percent of the adjusted value of the gross estate must consist of the value of the qualified farmland. A qualified heir includes the decedent's spouse, parents, grandparents and lineal descendants (including adopted children). It also includes all lineal descendants of either the decedent's spouse or the decedent's parents and the spouse of any qualified heir. It does not include uncles, aunts and cousins.  Qualified use means use for farming purposes such as crops, livestock, orchards and woodlands.  The adjusted value of the gross estate is the market value (highest and best use) of all the decedent's property as it is reduced by debts, claims against the estate, unpaid taxes, funeral expenses, estate administration costs, and losses incurred during  administration.  Material participation is a term without definite guidelines. As long as the farmland owner or a member of his or her family actually participates in the management and production activities of the farm operation, there should be no problem in satisfying the material participation condition.  Questions arise when farmland is leased to someone other than a member of the landowner's family either on a cash rental or crop share basis. Leased land will not qualify for the current use valuation if the landlord or a member of his family is not materially participating in the production and management of the farm.  Current use valuation formula Once the qualifying conditions are met, the executor of the estate can choose current use valuation. For this to be valid, the executor must obtain an agreement signed by each person (qualified heir) who has an interest in the farmland. The heir(s) must agree to maintain the farmland in a qualified use and to materially participate in the management of the farm for a period of 10 years after inheriting it. (Before 1982, it was 15 years). The qualified heir(s) has a two-year grace period to begin material  participation.  To calculate the current use value, divide the average annual gross cash rental per acre for comparable land in the locality minus average annual state and local real estate taxes per acre for such comparable land by the average annual effective interest rates for all new Federal Land Bank loans (see Table 2). Each average calculation is based on the five calendar years before the decedent's death.  Table 2. Effective interest rate for all new Federal Land Bank loans (St. Louis District).   1977 8.50 1978 8.71 1979 8.93 1980 9.20 1981 9.77 1982 10.37     G505 2 10/1993Current use valuation formula Current use valuation = (average annual gross cash rental — average annual state and local real estate taxes) / average annual effective interest rate for all new Federal Land Bank loans  If there is no comparable land from which cash rental rates can be obtained, net crop share rent may be used. Net crop share rent is the landlord's share of the crop minus any cash operating expenses paid by the landlord.  Current use valuation Example. Mr. Farmer, a widower, dies in 1982 and leaves all his property to his children.  • Mr. Farmer owned 1,000 acres of farmland with a fair market value of $1,200 per acre at his death. • He owned other property worth $300,000. • He had debts totaling $100,000 at his death. • Funeral and administration expenses amount to $50,000. These assumptions, along with hypothetical cash rent and property taxes for comparable land, are shown in Table 3. Obtain current use valuation by first subtracting the five-year average property taxes ($4.84) from the five-year average cash rent ($57) and then dividing the difference by the five-year average Federal Land Bank interest rate (10.37 percent from Table 2). This calculation gives a value of $503 per acre or about 42 percent of the fair market value.  Table 3. Special use valuation example (1982).  Assumptions: Fair market value at death $1,200/acre Fair market value six months later $1,240/acre Comparable land in locality: Year Cash rent Property taxes 1977 $50 $3.86 1978 53 4.29 1979 58 4.73 1980 61 5.48 1981 63 5.84 Five-year average $57 $ 4.84 Average effective Federal Land Bank interest rate = 10.37 percent. Current use value ($57 - $4.84 / 0.1037) $503/acre. Without current use valuation With current use valuation Value of land (1,000 acres) $1,200,000 $503,0001 Other property 300,000 300,000 Minus debts (100,000) (100,000)   Gross estate $1,400,000 $703,000 Less funeral and administrative expenses (50,000) 50,000) Adjusted gross estate $1,350,000 $653,000 Tentative estate tax $491,300 $212,410 Minus unified credit (62,800)2 (62,800)2 Estate tax due $428,500 $149,610 1Maximum reduction from fair market value is $700,000 in 1982 and $750,000 thereafter. 2Eligible unified credit for 1982.    If current use valuation is not used, the estate would owe $428,500 in federal estate taxes (see Table 3). If the estate is eligible for current use valuation, the federal estate tax can be reduced to $149,610.  This is a reduction of $278,890 (65 percent) in the amount of federal estate tax due on Mr. Farmer's estate. Of course, to receive this tax savings, Mr. Farmer's children must agree to keep the land in farming and materially participate in the management for 10 years after inheriting it.    G505 3 10/1993Not all $1,200-per-acre land will result in a similar reduction. The potential for estate size reduction varies by locality because rents, taxes, interest rates and market values differ, and these things determine the reduction.  Alternative valuation procedures If gross cash rent or crop share figures for comparable land are unavailable or if the estate executor and heirs decide not to use current use valuation, one of the following factors may be used instead of the current use valuation formula in determining the value of qualified farmland:  • Capitalization of the income which the property can be expected to yield from farming over a reasonable period of time under prudent management, using traditional cropping patterns for the area and taking into account soil capacity, terrain, and similar factors. • Capitalization of fair rental of land for farmland. • Assessed land values in a state that provides a differential or has a use value assessment law for farmland. • Sales of comparable farmland in the same geographical area far enough removed from a metropolitan or resort area so that non-agricultural use is not a significant factor in the sale price. • Any other factor that fairly determines the farm value of the property. Qualified estates probably will benefit most by applying the current use valuation formula. However, these alternative valuation factors also promise to remove some of the urban and speculative pressures built into owning farmland and are available if the current use valuation cannot be used.  Comparison of market values with current use values Table 4 compares market values with current use values for selected states. The calculations are based on average values and should not be considered representative of land in a given locality as required by the formula. The table does indicate that current use values are lower than market values.  Table 4. Comparison of market value and current use value.    State Average market value per acre (Feb. 1, 1981) Current use value assessment per acre for estate tax purpose1 Current use value as percent of Difference market value Arkansas $1,061 $299 $762 28 Illinois 2,133 750 1,383 35 Indiana 1,972 781 1,191 40 Iowa 1,941 773 1,168 40 Kentucky 991 384 607 39 Missouri 941 385 556 41 Oklahoma 662 173 489 26 Tennessee 1,042 341 683 33 1Calculated as the average gross cash rent minus real property taxes for the years 1976-1980 divided by the average effective interest rate for new Federal Land Bank loans for the same period. Source: Farm Real Estate Market Developments, CD87, ERS, USDA, 7/82.  Possible recapture of estate tax savings      The current use valuation provision has a clause for recapture of estate tax savings if the qualified heir fails to meet specified requirements. The failure of one heir to meet the requirements usually does not prevent other heirs from using current use valuation on their portion of the land. Recapture happens if one or more of the following occurs within 10 years of the decedent's death:  • The farmland is sold to an unqualified heir. • The farmland is taken out of its qualified use. • If, in any eight-year period, a total of three years goes by without material participation in the operation of the business by the decedent, the qualified heir or a family member.  G505 4 10/1993Basically, the qualified heir has to meet the same material participation requirements as the decedent. One slight alteration is that the five-of-eight years requirement may include years before or after the decedent's death. Material participation must be shown by the decedent, the qualified heir or a member of his family for a total of five years during any eight-year period, except for the two-year grace period or years when the decedent was retired or disabled. The three years of nonmaterial participation do not have to be consecutive for recapture to occur.  Failure to materially participate would result in a recapture of the difference between the federal estate tax due, without regard to the current use valuation and the amount due using the current use formula.  In case a surviving spouse, or a qualified heir who has not reached age 21, is disabled, or is a full-time student, the material participation test may be met by active management. Active management is defined as the making of management decisions of a business (besides the daily operating decisions).  Tests for material participation The tests for material participation are similar to those used for social security purposes for self-employment income. Presently, the following four tests serve as guidelines to the Social Security Administration and the Internal Revenue Service for determining material participation.  Test Number 1. The landowner or a family member must satisfy three (or more) of the following: (1) advance, pay or stand good for a significant part (half or more) of the direct costs of producing a crop; (2) furnish a significant part (half or more) of the tools, equipment and livestock; (3) advise and consult with the tenant periodically; and (4) inspect production activities  periodically.  Test Number 2. The landowner or a family member must regularly and frequently make decisions that significantly affect the success of the enterprise.  Test Number 3. The landowner or a family member must work at least 100 hours over a period of at least five weeks in a year in activities connected with producing a crop.  Test Number 4. If a landowner or a family member does those things which in total "show that the landlord is materially and significantly involved in the production of the farm commodities," the material participation condition is satisfied.  In most cases, if one of the four tests can be satisfied, the material participation condition will be met.  Implications of the current use valuation Beginning farmers may find purchasing farmland more difficult for several reasons.  First, with the current use valuation, the medium to large farm estates that were forced to sell off a section of the farm to pay estate tax debts under the pre-1977 estate tax law are now in a better position to avoid a forced sale. This will probably result in fewer land transfers upon farm estate settlements. Therefore, the opportunities for beginning farmers to purchase land may be reduced.  Second, estate planning choices during an owner's lifetime often involve a sale of farmland for retirement, travel or medical needs. The new law reduces the likelihood that such sales of real property will occur and increases the likelihood that the sale of personal property such as stocks and bonds will be selected to meet retirement needs.  Farmer-landowners now have the potential to substantially reduce federal estate taxes for heirs. But careful planning is required to meet all the qualifying conditions, so an estate can use the current use valuation. Decisions involving acquisition and disposition of property when the owner approaches retirement years are also important. For instance, the family member who owns the property at the time of death influences federal estate taxes.  Another problem deals with land purchased by the decedent within his last five years. The law requires that the decedent or a member of his family own the farmland at least five of his last eight years. When alternative land purchases are under consideration by an elderly farmer, and when one of those tracts is owned by a family member, the current use valuation rules would encourage purchasing farmland from the family member. Furthermore, farmland purchases probably would not be postponed until later years when the buyer is nearing retirement or is in bad health because the buyer would want to ensure ownership for at least five years before death.    G505 5 10/1993Sale of land by a qualified heir to a nonqualified heir may result in a recapture of estate tax savings. Sales to other qualified heirs such as parents, grandparents, brothers, sisters, their spouses, and descendants will not result in a recapture. For example, assume that two brothers (both qualified heirs) inherit land from their father. If one of the brothers decides to sell his interest to the other, no recapture will be triggered. If the land is sold to a nonqualified party, such as a neighbor or business partner, a recapture might result, but only on the land that was sold.  If you are leasing land or having your farm managed by a professional manager, your land may not qualify for the special farmland valuation alternative. The problem with this arrangement is the satisfaction of the material participation condition.  Leases should include provisions requiring material participation by the landowner or a member of his family in the management and production of the operation. Besides such lease provisions, the landowner-landlord or a family member should actually participate in the production and management activities in a material manner.  Summary Current use valuation can result in considerable federal estate tax reductions. If farming has been your life's occupation, and if you intend to pass the farm on to family members, you should have no difficulty in qualifying your farmland.  Meeting eligibility requirements for current use valuation takes more than just having a valid will or having a family member who wants to inherit the farm. The activities of the present landowner, especially if farmland is leased out, are most relevant. Get the new current use valuation requirements straightened out in your mind. Then discuss this new estate planning tool with your attorney.  Information on other new federal estate and gift tax changes, most of which were effective January 1, 1982, can be obtained at your county's University of Missouri Extension Center in MU publication M00068, Estate Planning for Missouri Families. The changes include new tax rates, an increased unified credit and an unlimited marital deduction.  To order, request G00505, Farmland Valuation for Estate Tax Purposes (75 cents).   • Issued in furtherance of Cooperative Extension Work Actsof May 8 and June 30, 1914, in cooperation with the United States Department of Agriculture. Ronald J. Turner, Director, Cooperative Extension Service, University of Missouri and Lincoln University, Columbia, Missouri 65211. • Un iversity Extension does not discriminate on the basis of race, color, national origin, sex, religion, age, disabilit y or status asa Vietnam-era veteran in employment or programs. • If you havespecial needs asaddressed by the Americans with Disabilities Act and need this publication in an alternative format, write ADA Officer, Extension and Agricultural Information, 1-98 Agriculture Building, Columbia, MO 65211, or call (573) 882-8237. Reasonableefforts will bemade to accommo date your special needs. G505 6 10/1993

Farmland valuation for estate tax purposes (1993)

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