FARM ESTATE TAX REDUCTION WITH 2032a
Special Land Use Valuation: Section 2032A
It is called Internal Revenue Code Section 2032A, Special Land Use Valuation. It is an alternative land valuation method used in the calculation of Federal estate taxes that must be paid at the time of estate settlement.
Despite increasing awareness of this estate tax planning option, special land use 2032a is generally misunderstood. 2032A is widely perceived as easy, uncomplicated, and the primary method of solving farm estate planning problems. Unfortunately, that perception often is based on a lack of accurate information concerning the complexities of how 2032A works, and of its true advantages and disadvantages. Our purpose here is to examine Section 2032A and its potential role when being used to reduce estate taxes.
Essentially, the purpose of Section 2032A is to allow farmland to be valued as farmland. Quite simply, Section 2032A usually establishes a productive value that is less than the farmland's fair market value (what it would bring if sold for its highest and best use). Valuing farm land at a lower cost can save a significant amount of estate tax which is levied on the adjusted total value of an estate. Indeed, in select situations it is the difference between a farm remaining in the family or being sold to raise the cash necessary to pay estate taxes.
For an estate to take advantage of Section 2032A special land use valuation, it must meet several conditions. The considerations for qualifying:
- The farm estate must be made up of "real property" used in farming that has a fair market value of at least 25% of the total value of the adjusted estate
- The farm assets, both real and personal, must make up at least 50% of the estate
- The farm real property must have been owned by the deceased (or a family member) for five of the previous eight years
- The real property qualifying for special land use must pass to a qualifying heir (usually a family member)
- For five of the preceding eight years, the qualifying real property must have been farmed or materially participated in by the deceased or a member of the family
- The executor (personal representative) must file an election for 2032A, with an agreement signed by each person having an interest in the property, consenting to the liability for any estate tax recapture that may occur later
You might be asking yourself, what does all that mean? Let's look at an example:
We'll say your estate has a fair market value of $ 1 million, and is made up of farmland valued at $250,000 (25%), equipment valued at $250,000 (25%), a house valued at $100,000 (10%), plus other personal property and investments valued at $400,000 (40%). In reality, of course, there are countless variations, and the percentage mix of individual assets rarely remains constant. For the sake of this example, your estate would meet both the 25% farm real estate and 50% farm assets rules.
Your estate would qualify only if you had owned the farmland and farmed it for five of the past eight years, and you were going to pass the farm to one or more of your children (or other qualified family members) who were going to continue to farm the land, or materially participate in the farming operation.
One of your heirs has to continue to farm, or be materially engaged in the farming operation, for another 10 years to ensure that any estate tax reduction is not recaptured.
If the qualifying farmland is taken out of production or sold to a non-family member during that 10 year period, there is a recapture of any estate tax reduction that previously was allowed.
In essence, the Section 2032A special land use valuation creates a tax lien against your farm in favor of the United States. A negative aspect of this election is that it makes the qualifying heir personally liable for the payment of the additional estate tax.
How then does Section 2032A reduce estate taxes? It establishes an alternative value based on a formula calculation. The value of the land is determined by using the excess of the annual gross cash rental for comparable farmland in the same vicinity, reduced by annual state and local real estate taxes, both determined on a five year average, then divided by the average annual effective interest rate of all new Federal Land Bank loans.
Let's look at another simpler example. If cash rents in your area have been, $200 on average for the past five years, and real estate taxes have been, $30 on average, an acre for same time period, and the new average Federal Land Bank loan rate is 6.38%, we would calculate the value as follows:
($200.00-$30.00) divided by .0638
($170.00 divided by .0638 = $2,664.00 Per acre special land use value.)
This value is the alternative value of your qualified land to calculate your estate taxes. The dollar difference in Federal estate taxes owed between fair market valuation and 2032A special use valuation becomes the amount of the lien that can be recaptured.
If the Section 2032A special land election is made, the land does not receive a total step-up in income tax basis. The basis is only adjusted to the alternative special use value. This could have adverse income tax consequences later for your heir(s) if the land is sold after the 10 year period. If a recapture occurs, there is a step-up in basis to fair market value as of the date of recapture.
A significant planning consideration arises if your intention is to have one or more of your children farm, yet you also have other non-active children. You could have a situation where the farmer heirs bears a greater share of the estate tax burden if a recapture occur, because they are personally liable for taxes due at that time. Too often, the result is that the farming heirs have no choice but to have their non-active siblings as their partners for the 10 year period so they share the personal estate tax liability. Careful consideration needs to be given to avoiding unfair treatment of your heirs.
An unexpected burden may arise when, after the 2032A election has been successfully made, the farming heirs discover that, because of the ever present tax lien, their lenders are not comfortable with the new debt to equity margins. For the farming heir, restricted borrowing capabilities could very well be the difference between the farm succeeding or failing.
As farmers age and move into retirement, they often divest themselves of farm implements and equipment by gifting or selling to their farming children and not replacing any of these assets. This is a potential area of imbalance when planning for the use of 2032A valuation. Over a period of time, farm assets can be reduced and non-farm assets increase because the retired farmer no longer is plowing cash back into equipment, but rather into savings or investment assets. The qualifying restriction arises when farm assets become less than 50% of the adjusted gross estate and the estate no longer qualifies for the 2032A special land use election. The alternative of investing in more land seems attractive at this point... however, keep in mind that to qualify, the farmland must have been owned and farmed for five of the previous eight years. The strategy of buying more land has a reduced impact in larger estates, because the limit of reduction can be no more than $870,000.
The myths of 2032A is that electing it is simple, and that it is the universal solution. Electing 2032A involves complicated issues and many components to monitor over time to ensure that the use of 2032A is consistent with your other estate planning criteria.
Here are several questions and issues to consider:
- Does your estate qualify for 2032A election today?
- Assuming you live another 10 or 20 years, will your estate still qualify for the 2032A election?
- Could your heirs successfully operate under 2032A if it were elected today? What about in 10 or 20 years?
- Would restricted borrowing capabilities caused by the 2032A election significantly impact your farming heirs?
- Who would bear the burden of the potential 2032A recapture?
- Will your farming heirs want to be partners with your non-participating heirs?
- Have you discussed these issues with your personal representative (executor), farming heirs and estate planning attorney?
- Is the limited adjustment in income tax basis under the 2032A election a critical issue for my heirs?
- What are the other potential solutions I should explore?
- Is 2032A the best alternative for my estate and my heirs?
IRC Section 2032A
IRC Section 2032A has its place in farm estate planning. It can provide a viable alternative to other estate tax planning techniques. But, it is important to understand that:
- There are potential pitfalls as well as benefits to using this election
- There is no guarantee a farm estate will qualify at the time the election is needed.
Many estate planners suggest that relying on the use of 2032A as the principal method to reduce estate taxes is not estate planning but rather the absence of it.
Installment method to pay estate taxes Farmers and small-business owners often fear that their loved ones might have to sell the family business to pay death taxes. In reality, the probability of a forced sale solely to pay estate taxes is small for three reasons.
First, you can leave a substantial amount of property to your heirs free of estate taxes. All property left to your spouse is exempt from any estate taxes. In addition, the 2011 estate tax unified credit allows $5,000,000 in property to pass to other heirs tax-free. This "tax free" amount will decrease to $1,000,000 after 2013.
Second, the Internal Revenue Service allows a closely held family business to value land on the basis of its current use” rather than on the standard fair market value. Current use valuation (2032a) of farmland usually can reduce the land. In turn this can reduce potential estate taxes.
Third, tax laws allow for delayed payment of federal estate taxes. These provisions can be useful for estates that experience shortages of liquid assets upon the death of the estate owner.
Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.