Federal Estate Taxation and "Special Use" Valuation of Certain Properties
Calculation of the Value of Estate Assets
Estate taxes are calculated based upon the value of the assets in the estate. One duty of the executor or administrator is to inventory all estate assets and assign a value to each or obtain an appraisal. The sum of the asset values, less allowable deductions for payment of debts, such as funeral and last illness expenses, is the basis for calculating estate tax.
In general, the value assigned to an asset must be its “fair market value” (FMV) at the time the decedent died, with some exceptions. The Internal Revenue Service (IRS) defines FMV as the price at which property would change hands between a willing buyer and a willing seller, neither of which is under any compulsion to buy or sell, and both of which have reasonable knowledge of relevant facts. There are, however, some exceptions to the FMV rule, including the special use valuation discussed in this article.
Special Use Valuation
Commentators have long decried the disappearance of the family farm. One reason often asserted for the disappearance is that it became increasingly difficult for farming couples to pass on the farm intact to their kids. Farmland located near urban areas often has a FMV for the land itself, for potential housing or other development, which greatly exceeds what the farmers originally paid. The inflated FMV could result in estate taxes where there is insufficient liquidity in the estate to pay the tax, requiring that all or a sizeable portion of the land must be sold.
In recognition of this problem, the IRS and federal tax law allow a different valuation for certain farm and closely-held business (those owned by a small number of shareholders) properties. For qualifying property, and providing other requirements are met, valuation may reflect “current use” value, instead of their FMV.
Special Use Valuation Methods
The preferred method of calculating current use value for farm property is based on rents for comparable farm property in the area. The cash rental of the comparable property is “capitalized.” That means that average rental of comparable land, minus applicable real estate taxes, is divided by the average annual effective interest rate charged for new loans by the Federal Land Bank.
For example, Caroline dies owning a 1,000 acre farm that she bought and farmed. FMV for the land itself is $1 million, but comparable farmland is rented out at $75,000 per year, with annual real estate taxes of $10,000 per year. If the current Land Bank loan rate is 10%, then the current use value is $650,000 ($75,000 – $10,000 ÷ .10). The taxable estate is thus reduced by $350,000. However, there is a limitation to this reduction; the reduction cannot exceed $750,000, increased yearly after 1998 to account for “cost-of-living” inflation.
If there is no comparable cash rental property, the value of sharecropper rental can be used. Sharecroppers are tenant farmers who give a set portion of their crop to the owner of the land. Other methods of calculating special use value are also allowed.
General Requirements for Special Use Valuation
- The decedent must have been a U.S. citizen or resident at the time of death.
- The property must be real property located in the U.S.
- At the time of the death, the property was used by the decedent or a family member for farming or in the trade or business, or was rented for such use by family members on a net cash basis.
- The real property was passed from the decedent to a “qualified heir,” i.e., a spouse, ancestor (e.g., parent), lineal descendant, or certain other beneficiaries.
- The property was owned and used in a qualified manner (for farming or in the business) by the decedent or family during for five of the eight years prior to the death and the decedent and/or family “materially participated” in the farming or business through physical work and/or management participation.
- The adjusted value (FMV minus debt) of the real or personal property used as the farm or in the business must be at least 50% of adjusted gross value of the estate.
- The qualified real property’s adjusted value must be at least 25% of the adjusted value of the gross estate.
- An appropriate election for special use treatment is made on the estate tax return.
Recapture of Tax Savings Under Certain Circumstances
If, within 10 years of the decedent’s death, the qualified heir disposes of any interest in the qualified property (other than to a member of his or her family) or the qualified heir ceases to use the real property for a qualified purpose, additional estate taxes may be imposed, including the estate tax savings. There is, however, up to a two year “grace period” allowed before the 10 year qualified use period commences, although the 10 year period is then extended accordingly.
The relative advantages and disadvantages of electing special use valuation treatment may be unclear in light of the uncertain future of the federal estate tax and the obligations to maintain the qualified use. Making the necessary election and calculations, and ensuring compliance with the laws and regulations, make assistance from a tax professional advisable.
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