Q. Is farmland entitled to any special valuation for purposes of Federal estate taxes?
A. As referenced in a quote famously attributed to Mark Twain, “the only two certainties in life are death and taxes.”Estate planning is intended to address those two inevitabilities by determining in advance how property and other assets will be distributed upon death, and to do so in a way which minimizes the estate’s liability for Federal and/or New York estate taxes to the greatest extent permitted by law.
Careful estate planning generally requires the assistance of both legal and tax professionals in order to develop a plan specifically tailored to the meet an individual’s unique needs and desires.While this article offers some general information regarding the valuation of farmland for Federal estate tax purposes, it is certainly not intended to offer any specific estate planning or tax advice.
Understanding Estate Taxes and the IRS
The Internal Revenue Service has described the “estate tax” as a tax on your right to transfer property at your death. Generally speaking, your estate consists of everything you own or have an interest in at the date of your death. Estate taxes are based on the current “fair market value” of this property, not necessarily what you paid for them or what they were worth at the time you acquired them. The fair market value of the “gross estate” is then reduced by any available deductions (which may include, for example, the value of any mortgages or other debts, or property passing to a surviving spouse) to arrive at a “taxable estate” on which the tax due is computed. That tax, however, is subject to a “unified credit” which effectively reduces the computed tax so that, currently, only taxable estates that exceed $5,000,000 will actually be subject to paying taxes.That threshold, however, may be reduced to as low as $1,000,000 for decedent’s dying in 2013 absent action by Congress.
Farmland owned by the decedent would be included in the estate, and would ordinarily be assigned a value based on its fair market value if sold for its highest and best use (which may not be for use in farming). Depending on the amount of land at issue and the resulting value, using the fair market value of farmland might result in an estate tax so high that the decedent’s heirs could find themselves forced into the situation of having to liquidate farm assets in order to cover the tax liability.
Know Special Land Use Valuation
In the interests of avoiding that situation and promoting the continuation of family farm operations from one generation to another, Internal Revenue Code (IRC) Section 2032(a) offers estates an alternative special land use valuation for farmland which may result in either a lower tax liability or no liability at all. Under the alternative valuation of Section 2032(a), the value of qualifying farmland is determined based on the net five-year average annual cash rental value of comparable farmland in the same vicinity, after reduction for state and local real estate taxes, capitalized by the average annual effective interest rate applicable to new Federal Land Bank loans. While the application of the formula can be complicated, the net result is that the decedent’s farmland is valued as farmland, and not necessarily at its fair market value. Since farmland values tend to be lower than fair market values, application of the Section 2032(a) alternative valuation may result in lower estate values, and in turn, result in a lower tax liability.
The availability of the Section 2032(a) valuation is subject to a number of qualifications, three of which are addressed here. First, the farmland must comprise at least 25% of the total value of the estate, and total farm assets (real and personal property) must comprise at least 50% of the total value of the estate. For example, an estate with a value of $1,000,000, of which $250,000 represented farmland value and $250,000 represented farm equipment value, would meet the 25%/50% requirement. Second, the farmland must have been owned and farmed by the decedent (or a family member) for five of the preceding eight years. Third, the farmland must pass to a qualifying heir, which is usually a family member.
What Are the Tax Benefits?
The tax benefits of Section 2032(a), however, are subject to the decedent’s heirs continuing to farm the property or be materially engaged in the farming operations, for another ten years. If the farmland is taken out of production or sold to a non-family member during that ten-year period, any estate taxes saved as a result of Section 2032(a) are subject to recapture from qualifying heirs.
As an estate and tax planning tool, Section 2032(a) offers both advantages and disadvantages to farmers and their heirs who intend to pass an ongoing farm operation from one generation to the next. Farm owners should carefully discuss Section 2032(a) with their legal and tax professionals as part of their overall estate and tax planning strategies. Consistent with IRS requirements, please note that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code, or promoting, marketing, or recommending any transaction or matter addressed in the article.
If you are planning your estate, our real estate lawyer in Albany can help ensure you know how your decisions know will affect your family in the future. Get in touch with us to schedule your free consultation.