Special report on estate planning for farmers: Part 3 of 7

David Repp Iowa Real Estate & Land Use Iowa Tax Law Iowa Trusts & Estates Law Iowa Dickinson Law Des Moines Iowa

Posted on 05/06/2011 at 12:50 PM by David Repp

In a special report prepared in conjunction with a presentation at the University of Iowa College of Law's 2011 Spring Tax Institute, David Repp takes in in-depth look at estate planning considerations for farmers and other landowners.  Part 3 of 7, below, addresses special use valuation. Special Use Valuation In General The Code Section 2032A special use valuation rules allow a reduction of up to $750,000 (adjusted for inflation) in the value of real property (land and buildings) used in a family owned farm or other family business that is closely held. The inflation-adjusted reduction amount is $1,020,000 for estates of decedents dying in calendar year 2011. As a primary matter, the property must satisfy the following threshold tests before it will qualify for special use valuation under Code Section 2032A:

  1. The decedent, at the time of his death, must have been a U.S. citizen or resident, Code Section 2032A(a)(1)(A);

  2. the real property for which the special use valuation is sought must be located within the United States and held by decedent or by a closely-held family business in which decedent had an interest;

  3. the real estate must pass to one of the decedent's qualified heirs (surviving spouse or family members – under a broad definition of family), Code Section 2032A(e)(1)-(2);

  4. the decedent must have been using the property for "special use" purposes (farming or any other trade or business) at the time of death, or must fit within one of the exceptions for a retired or disabled person who, at the time the retirement or disability began, was using the property for the special use purposes – in which case the special use must have been taken over by a family member, Code Section 2032A(b)(1)-(2);

  5. the special use must have occurred for five out of the eight years preceding death (or retirement or disability); however, the five-year period need not have been continuous, Code Section 2032A(b)(1)(C);

  6. under Code Section 2032A(b)(1)(A), the value of special use real and personal property must total 50 percent or more of the value of decedent's gross estate (with both the property and the estate adjusted for unpaid mortgages or similar indebtedness as provided in Code Section 2053(a)(4)); and

  7. under Code Section 2032A(b)(1)(B), the value of special use real estate must total 25 percent or more of the value of decedent's gross estate (with both the real property and estate adjusted for unpaid mortgages or similar indebtedness as provided by Code Section 2053(a)(4)).

If these requirements are met, the executor is allowed to elect special use valuation of the land and buildings used in the family business. Code Section 2032A(a)(1)(B). That is, for estate tax purposes, the executor may value the property in its capacity as a farm or other special use, rather than at its value in its highest and best use, as is generally required. Code Section 2032A(a)(1).

Practice Tip: This limitation is generally applied as of the date of death; however, if alternate valuation, discussed in Section 753.2, is elected, it is applied as of the alternate valuation date. Rev. Rul. 88-89, 1988-2 C.B. 333.

The value of a farm for farming purposes generally is determined by dividing the excess of the average annual gross cash rental (or the average net share rental, if there is no comparable land from which the average annual gross cash rental can be determined) for comparable land used for farming purposes and located in the locality of the farm over the average annual state and local real estate taxes for comparable land, by the average annual effective interest rate for all new Federal Land Bank loans. Code Section 2032A(e)(7). In general, the valuation is computed as of the date of death; however, if alternate valuation is elected, the valuation is computed as of the alternate valuation date (six months after date of death). Rev. Rul. 88-89, 1988-2 C.B. 333. The IRS annually publishes a list of average effective interest rates on new loans under the Farm Credit Bank system.  The most recent rates published are for 2009 published in Rev. Rul. 2009-21. The most recent published rate for Iowa is 6.50 percent.  Rev. Rul. 81-170, 1981 C.B. 454, contains an illustrative computation of an average effective interest rate.

Example: Jack died in 2011 owning 1,000 acres of farmland.  Assuming the farmland meets all the requirements of IRC § 2032A, and assuming further that the average annual gross cash rental less property taxes is $300 an acre, the special use valuation would be $4,615 per acre ($300 / 0.065).

This method of valuation does not apply if the executor of the decedent's estate does not document comparable rented property. Reg. Section 20.2032A-4.  In this case, or in the case of a closely-held business other than a farm, the special use value must be determined by considering the following factors:

  1. The capitalization of income which the property can be expected to yield for farming or closely-held business purposes over a reasonable period of time under prudent management using traditional cropping patterns for the area, taking into account soil capacity, terrain configuration, and similar factors;

  2. the capitalization of the fair rental value of the land for farm land or closely-held business purposes;

  3. assessed land values in a state that provides a differential or use value assessment law for farmland or closely-held business;

  4. comparable sales of other farm or closely-held business land 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 sales price; and

  5. any other factor that fairly values the farm or closely-held business value of the property. Code Section 2032A(e)(8).

Again, the value is computed as of the date of death, unless alternate valuation is elected. Rev. Rul. 88-89, 1988-2 C.B. 333. Property may be considered special use property even if it was not held directly by the decedent in a sole proprietorship. Property the decedent held indirectly through a partnership, trust, or corporation can qualify for special use valuation. Reg. Section 20.2032A-3(b). Where the ownership is indirect, however, the decedent's interest in the business must not only meet the Code Section 2032A tests set forth above, but also must qualify under Code Section 6166(b)(1) as an interest in a closely-held business for all the relevant time periods of Code Section 2032A. Similarly, directly owned real property that the decedent leased to a separate closely-held business may be considered special use property, but only if the separate business also qualifies as a closely-held business under Code Section 6166(b)(1) (and for the required Code Section 2032A time periods). Property not used in a trade or business does not qualify for special use valuation.

Example: Jack, the decedent, owned land that he leased to a farming corporation owned and operated entirely by him and his four sisters. Because the corporation was owned by Jack and fewer than 45 members of his family, the land he leased to the corporation may be eligible for special use valuation. Similarly, Jack's indirect interest in real property held by the corporation may qualify for special use valuation.

It is not enough that the property be used in a family business. The person who acquires the property from the decedent or the decedent's estate must be a qualified heir - a family member who continues to use the property in the family business for ten years and who materially participates in that business for eight years following the decedent's death. Code Section 2032A(c) and Code Section 2032A(b)(1)(C). An heir has up to two years to begin using the real property in the family business; the ten-year continuing-use period commences when that use begins. Family is defined broadly for Code Section 2032A purposes. Under Code Section 2032A(e)(2), the members of the decedent's family include his ancestors, spouse, lineal descendents, lineal descendents of decedent's spouse or parent, and any spouse of a lineal descendent of decedent's parent or lineal descendents.

Example: Jack's will leaves his share of the family corporation equally to his second wife's son Bob Edwards and to Sally Jones, who has been an employee of the family company for five years. Although Bob Edwards is not Jack's son and was never adopted by Jack, he is "family" under Code Section 2032A(e)(2) as the lineal descendent of the decedent's spouse. Sally is married to John Jones, who is the grandson of Brian Jones, Jack's mother's second husband. Brian adopted Jack shortly after he married Jack's mother. Because Sally, the wife of Jack's great-nephew John, is the spouse of a lineal descendent of the decedent's parent, she qualifies as a family member. The absence of a biological relationship between Jack and Sally is irrelevant; Sally qualifies by her marriage to John, who qualifies through his great-grandfather Brian, who adopted Jack and so is considered Jack's parent. If, after marrying Jack's mother, Brian had treated Jack as a son but had not adopted him, the required family relationship would not exist between Jack and Sally.

Because of the percentage tests that must be met to qualify property for special use valuation, disqualification of one heir as not a family member can make Code Section 2032A inapplicable to any of the decedent's property.

Example: The real property Jack owned indirectly through the family corporation was passed to Bob Edwards and Sally Jones. The value of Jack's indirect share of the corporation's real property constitutes 50 percent of his estate, meeting the 50-percent test of Code Section 2032A(b)(1)(A). But if Brian Jones had not adopted Jack after his marriage to Jack's mother, Sally would not qualify as a family member. Consequently, Sally's half share of Jack's interest in the family corporation would not be counted in determining the value of special use property. When Sally's share is not counted, then the qualified real property in Jack's estate would constitute only 25 percent of his total estate. Practice Tip: After a decedent's death, it is too late to take steps to qualify property for Code Section 2032A treatment. Tax professionals who advise the owners of family businesses should alert their clients to the availability of the Code Section 2032A special use valuation and help to determine whether any of their intended heirs will fail to meet the definition of family member and so disqualify the estate from Code Section 2032A treatment. To avoid this result, the family-business owner may want to pass other property to a non-qualifying person.

For the special use valuation to apply, the family business must qualify as a farm or other trade or business in order for the property to be considered to have been used for special use purposes. Under Code Section 2032A, a trade or business is an active business (for example, a manufacturing, mercantile, or service enterprise), or the raising of agricultural or horticultural commodities -- as distinguished from passive investment activities. For the purposes of the special use valuation, a closely-held business is defined under Code Section 6166(b) (relating to the closely-held business interest estate tax payment extension) as an entity (e.g., a sole proprietorship, a corporation, or partnership), in which the decedent had at least a twenty percent interest (either voting stock of a corporation or total capital interest of a partnership) or which was owned by not more than 45 members. Code Section 2032A(g) A decedent's interest in a holding company can also qualify as a closely-held business if such stock is not-readily tradable and its subsidiary (or subsidiaries) is engaged in a trade or business. For decedents dying before January 1, 2002, an entity could only have been owned by not more than 15 members in order to qualify as a closely-held business under Code Section 6166(b), prior to amendment by Pub. L. 107-16, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Section 571. Passive rental of property to someone not a member of the decedent's family does qualify as a special use. The decedent or a member of the decedent's family must own an equity interest in the operating business. A trade or business is not necessarily present even though an office and regular hours are maintained for management of income-producing assets, as the term business is not as broad under Code Section 2032A as under Code Section 162. Additionally, no trade or business is present in the case of activities that are not engaged in for profit. Transfer To Qualified Heirs While an estate's transfer of special use property to qualified heirs does not compromise its special use election in the same way that a sale to a non-qualified heir does, the estate is required to recognize gain on the transfer. Code Section 1040(a), prior to amendment by EGTRRA, Section 542(d). However, the amount of gain required to be recognized by the estate is limited to the post-estate tax valuation appreciation of the special use property. Thus, even though the estate was able to take advantage of a lower than fair-market-value valuation for the property under the special use rules, the estate is not required to recognize any gain in excess of the property's appreciation between the decedent's date of death (or the alternate valuation date) and the date of the transfer, provided that the transfer is made to a qualified heir. Code Section 1040(a), prior to amendment by EGTRRA, Section 542(d). The same rule applies to transfers of special use property from trusts. Code Section 1040(b), prior to amendment by EGTRRA, Section 542(d). The transferee qualified heir's basis in the acquired property, however, reflects the special use valuation used for estate tax purposes. Code Section 1040(c), prior to amendment by EGTRRA, Section 542(d). The basis of the special use property in the hands of the transferee qualified heir is the basis of the property immediately before the transfer (i.e., typically the special use value) increased by the amount of gain recognized by the estate (or the trust) on the transfer (i.e., the appreciation between the estate tax valuation date and the date of the transfer). Code Section 1040(c), prior to amendment by EGTRRA, Section 542(d). Loss of Special Use Treatment If the qualified heir discontinues the qualifying use of the property that is, if the property is no longer used in the family business because the heir sells it to someone outside the family or simply changes its use the special use valuation tax break is recaptured via the imposition of additional estate tax. Code Section 2032A(c). The additional tax is the difference between the regular estate tax and the reduced amount that was paid because of the special use valuation. However, if the property is sold at arm's length for a price less than the appraised market value for estate tax purposes, the sales price acts as a cap on the amount of additional estate tax that can be collected. Code Section 2032A(c)(2). If the heir sells (or discontinues use of) only a part of the special use property, the amount of additional tax is prorated. Code Section 2032A(c)(2)(D). If there is a series of partial sales, in no case will the combined amount of additional tax due exceed the difference between the regular estate tax and the reduced estate tax that resulted from the special use valuation. Code Section 2032A(c)(2)(D)(ii).

Compliance Tip: The additional tax is reported on and paid with Form 706-A, United States Additional Estate Tax Return, which must be filed by the qualified heir when any taxable event occurs, or when there is an involuntary conversion or exchange of the special use property even if the conversion or exchange is non-taxable. Caution: Pub. L. 105-34, the Taxpayer Relief Act of 1997, Section 504(a), added Code Section 2032A(c)(7)(E), allowing certain leases of qualified property to come within the definition of qualified use for the purposes of the special use valuation. Effective for leases entered into after December 31, 1976, Code Section 2032A(c)(7)(E) provides that the rental of the qualified property by a surviving spouse or a lineal descendant to his or her family members is not considered a disqualified use. Because the effective date of the 1997 law reached back to leases entered into after December 31, 1976, Congress also extended the statute of limitations for those estates seeking a refund for estate taxes paid in conjunction with what had been deemed to be a disqualified use between 1977 and 1997. EGTRRA, Section 581, extended the statute of limitations for estates seeking to claim refunds or credits of overpayment of estate taxes pursuant to Code Section 2032A(c)(7)(E). Specifically, Section 581 of EGTRRA, extends the time for estates to file for a refund or credit of any overpayment of tax resulting from the application of Code Section 2032A(c)(7)(E) for up to one year after June 7, 2001.

A qualified heir can elect to increase the basis of the property by the difference between its fair market value at the date of the decedent's death (or the alternate valuation date) and the special use value if the additional tax is imposed. Code Section 1016(c). This increase in basis gives the heir the same basis in the property that she would have had if the special use valuation election had not been made. It is deemed to have occurred immediately before the disposition or cessation resulting in the imposition of the recapture tax. The election is made by attaching a statement to Form 706-A, Additional Estate Tax Return. Reg. Section 301.9100-4T(f). It must be made by the due date of Form 706-A, which is six months after the date of the event that gave rise to the recapture of estate tax. Once made, it cannot be revoked. Reg. Section 301.9100-4T(g). A qualified heir who makes the election must pay interest on the additional estate tax, computed from the date that is nine months after the date of the decedent's death, to the date that the tax is paid. Code Section 1016(c)(5)(B). Election Procedure To make a Code Section 2032A election, the executor must check the appropriate box on the Form 706 (estate tax return), complete the mandatory schedules, attach a legal description and two appraisals of the property (one showing market value, one showing special use value), and obtain the signatures of heirs and interested parties on the election agreement that is submitted as part of the schedules. If it is not possible to obtain all the signatures by the return due date, the executor can submit the election agreement but must provide the missing signatures within 90 days of receiving notice from the IRS that the signatures are missing. Failure to provide the other required information along with the estate tax return may result in loss of the election privilege. To assist the return preparer, the instructions to Form 706 include a checklist of items required for an effective Code Section 2032A election. If it is not clear whether the estate or some part of it will qualify for special use valuation, the executor may decide to make a protective Code Section 2032A election. Reg. Section 20.2032A-8(b). To make a protective election, the executor must not only check the Code Section 2032A box on the Form 706, but also check the box marked "Protective Election" in Part 1 of Schedule A-1 and provide a limited amount of additional information. An amended Form 706 with completed Code Section 2032A schedules and required attachments must be filed within 60 days after the executor receives notice that the estate qualifies for Code Section 2032A treatment. Reg. Section 20.2032A-8(b). The Code Section 2032A election is irrevocable. Code Section 2032A(d)(1). As a practical matter, the last timely filed Form 706 controls; a later, amended estate tax return not electing Code Section 2032A would override an earlier return making the election. Similarly, the executor who files a Form 706 without electing special use valuation can submit an amended return that makes the election, provided the amended return is filed by the due date (with extensions). For example, if the due date is January 10, 1999, and the executor files a return on January 6, 1999, an amended return electing Code Section 2032A treatment may be filed up to six months after the January 10 due date. The executor who misses that deadline may still be able to make an effective Code Section 2032A election by submitting an amended return electing special use treatment within twelve months following the return's extended due date, provided the IRS has not begun examining the previously filed return. Special Use Property and the Code Section 6166 Payment Extension When property is used by a closely-held business, as it must be to qualify for special use valuation under Code Section 2032A, the estate tax attributable to that property may also qualify for extended-payment treatment under the rules of Code Section 6166. A special lien is available under Code Section 6324A to secure the Code Section 6166 extended payments and thus release the executor from liability.  Code Section 6324A(a); 6324A(d)(2). The extension available for the payment of estate tax attributable to a closely-held business interest is discussed in Section 755.3(c), and the special lien available under Code Section 6324A is discussed in Section 755.4(b). Code Section 6324B Special Lien for Special Use Property The Code Section 2032A special use valuation that reduces estate tax is conditioned on continued "special use" of qualifying real property for ten years and material participation of the heir or heir's family member for eight of those ten years. These conditions may be violated by sale of the property outside the family or by discontinuation of the qualifying use, resulting in an obligation to pay additional estate tax essentially "recapturing" the amount of tax that was not paid because of the special use valuation. Consequently, Code Section 6324B imposes a lien on the special use real estate for the duration of the eight-year and ten-year periods. This special lien is in the amount of the adjusted tax difference attributable to the real-estate interest.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed. 

- David Repp


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