Which IRC rules apply to the division of farmland at the death of a spouse? What options are available for valuing agricultural property? How might the pending phase-out of the estate tax and the step-up-in-basis rule impact farmers and ranchers?
Answers to these questions, among others, were the focus of an audio-web conference sponsored this month by the Society of Financial Services Professionals, Bryn Mawr, Pa. Titled “Transferring Your Farm or Ranch to the Next Generation,” the educational session was hosted by Roger McEowen, an associate professor of agricultural law at Iowa State University, Ames Iowa.
How a farm or ranch is divvied up after the death of a first spouse will depend on when the husband and wife established the spousal joint tenancy governing their interests in the property, McEowen said. In cases involving a post-1981 death and a marital joint tenancy established after 1977, the surviving spouse may invoke a “fractional share rule.” One half of the property is therein taxed at the death of the first spouse if husband and wife are the only joint tenants.
But McEowen observed that court rulings now require use of the less favorable “consideration furnished rule” where the couples established a spousal joint tenancy prior to 1976 and where the first spouse died after 1981. Upshot: All of the property is taxed in the estate of the first spouse to die except to the extent the surviving spouse proves that he or she contributed to the property’s acquisition.
“The solution to this problem is to sever joint tenancies and transfer the property through the terms of the will or trust at the time of death,” said McEowen.
And what if the will needs updating? Rather than amending the document, which can be time-consuming, McEowen advised that farm clients list tangible property (such as household furnishings) in separate, written memoranda. Many states permit such memoranda for the disposal of property not identified in the will or trust documents.
Advisors should also counsel clients to prepare power of attorney (durable or springing) and health care power documents. Should the client’s health seriously deteriorate, the party in whom these powers are vested can act on the client’s desires with respect to the disposition of the estate.
How much of the farm or ranch escapes estate tax will hinge in part on the property’s valuation at the time of death, McEowen said. Eligible clients can leverage a special use valuation permitted under IRC Section 2032A, potentially reducing a farm property’s value (and, hence, estate tax to be paid) to an amount less than its fair market value. For 2006, the special use rule allows for a reduction in a land’s valuation by up to an inflation-adjusted $900,000.
McEowen cautioned, however, that the IRC section is highly technical; without a firm grasp of the code, advisors can easily miss provisions that can invalidate eligibility. Among them: a requirement that heirs continue to own and operate the farm or ranch for at least 10 years; and satisfaction of varied post-mortem tests.
But for those who qualify, the benefits can be substantial. “Individuals electing this special use valuation will generally see drops in the estate value as reported on their estate tax return of between 40% and 60%,” said McEowen.
He warned, however, of potentially adverse consequences stemming from the Economic Growth and Tax Relief Reconciliation Act of 2001. In conjunction with a temporary phase out the estate tax in 2010, EGTRRA will replace the step-up in basis rule with a modified carryover basis system.
With some exceptions, the cost basis for property acquired from a decedent dying in 2010 will be equal to the decedent’s basis before death or the fair market value of the property at death, whichever is less. The change could thus entail an accounting nightmare because farm and ranch heirs will have to know the decedent’s basis information when they sell inherited property.
Adoption of a modified carryover basis system, said McEowen, has prompted “great concern” among farmers who have held land for decades. Without a full step-up-in-basis, heirs to their lands could get socked with high capital gains taxes when they sell the properties. A survey by Iowa State University survey of Iowa land values, McEowen noted, shows that farmland values now hover around $3,000 per acre, up from an average of $250 to $500 per acre when the properties were acquired during the 1940s and 1950s.
If the estate tax is permanently repealed, heirs of large estates would have substantially more assets to invest. And, observed McEowen, some of it would go into farmland. One result would be an increase in farm asset ownership by the very wealthy. Another would be a rise in the proportion of farmland that is rented.
McEowen suggested, however, that reform of the estate tax is the more likely scenario. He asserted that such a revision, if done right, would not adversely impact government revenues.
“By establishing an [estate tax] exemption amount of between $3.5 million and $5 million per decedent, indexing the exemption to inflation and retaining the step-up-in-basis rule, the federal government can continue to enjoy the same level of revenue with fewer farmers ever having to pay estate tax,” he said. “But action also has to be taken by the states, many of which have decoupled their estate taxes from the federal estate tax.”
McEowen cautioned advisors to not overlook long-term care insurance — in particular policies offering lifetime coverage — when devising a comprehensive plan for protecting estate assets. Those clients who have built up a large nest egg should entertain policies that delay the payment of benefits for the first six months of long-term care, thus permitting a lower premium.
Clients who can’t get the insurance because of their advanced age might consider selling tracts of land in installments to family members, the revenue generated thereby paying for long-term care.
“That keeps the assets in the family,” said McEowen. “But it is absolutely essential that a sales contract be carefully drafted to provide that the agreement is canceled at death if only a fractional part of the contract has been paid for.”