Special Use Valuation and Cash Leasing

Overview

Most assets are valued at fair market value as of the date of the decedent’s death.  The IRS defines fair market value as the price at which a willing buyer and a willing seller would exchange the property, neither being under any compulsion to buy or sell and each having full knowledge of all relevant facts.  Treas. Reg. § 20.2031-1(b).  For stored grain, for example, fair market value is what the elevator would pay.  For feed on hand at death, selling price is an appropriate measure of fair market value.

A major exception to the general valuation rule is special use valuation. I.R.C. §2032A.  The provision contains many complex rules, and the proper type of lease arrangement is a significant issue for many estates seeking to qualify to make a special use valuation election or avoid having to refund the taxes saved by the valuing farm or ranch real estate at the lower use value amount. 

Cash leases and special use valuation is today’s topic. 

Special Use Valuation 

The only major exception to the willing buyer/willing seller test is special use valuation of land used in a farming or ranching business. I.R.C. § 2032A.  Special use valuation allows the executor of an estate to make an election on the estate’s return to elect to value real property devoted to farming or ranching (or other closely-held businesses) at its special use or “use” value rather than its fair market value.  This valuation provision, however, cannot reduce the gross estate by more than $1,120,000 (for 2017).  Consequently, special use valuation has the potential to be an enormous federal estate tax saver for agricultural estates and can easily trim more than $100,000 off the federal estate tax bill with the right set of facts.  Theoretically, the maximum saving could be $448,000 (40 percent of $1,120,000) in 2017, but savings of that magnitude are unusual. 

The idea behind the provision is to make it easier for a family farming or ranching business to continue in operation without losing some of the land and other assets to pay the federal estate tax bill.  That was a particular concern when the exemption from federal estate tax was much lower than it is today, but with the increase in land values in recent years (with some pullback in recent months) special use is still important.  It also is useful for farming operations that are experiencing upward price pressure on land values due to the potential for commercial/residential development, but where the family wants to continue farming. 

A special use valuation election requires a lot of work for the practitioner.  Not only does a great deal of data have to be acquired in determining the special use value of the decedent’s land, a decision has to be made on how much of the land to make the election on, and each pre-death requirement must be satisfied so that the election can be made.  In addition, there are numerous post-death requirements that must be satisfied for 10 years after the date of death.  Those rules are in place to ensure that the provision is limited in use to those that are truly farmers, and to make sure that the land continues to be farmed by the decedent’s family for at least 10 year after the decedent dies.

Cash leasing.  There are special rules that apply to leases.  This is a big issue for estates where the special use valuation election is being considered to be utilized or has been made.  In the pre-death qualification period, cash renting to a member of the family or family-owned entity is permissible. Treas. Reg. §20.2032A-3.  However, the land must not be cash rented to anyone else. In the post-death period the rule is different. 

Specifically, there can be no cash renting in the post-death period, with three exceptions:  (1)  a surviving spouse can cash rent to members of the surviving spouse’s family (I.R.C. §2032A(c)(7)(E)); (2)  cash renting is permissible during a two-year grace period which extends for two years after the date of death; and (3) a lineal descendant of the decedent can rent the land on a “net cash basis” to a member of the lineal descendant’s family.  If the post-death bar on cash leasing (outside of the exceptions) is violated, then the tax saved by making the election must be paid back, with interest.  This is known as “recapture.”

So, if the land isn’t leased to a family member pre-death, can the estate make the special use election?  What type of lease qualifies post-death? If the decedent was an active farmer at the time of death, then there is no problem.  If the decedent was a landlord, the rules require the decedent to have borne the risk of production and risk of price change for a set period of time before death if the lease isn’t to a family member.  That means a crop-share/livestock share lease that subjects the landlord’s share to self-employment tax.  Post-death, each qualified heir must have an equity interest in the operation. I.R.C. § 2032A(c)(6)(A).  Failure of a qualified heir to meet the qualified use test causes recapture with respect to that heir’s interest.  As noted above, that means cash renting in the recapture period outside of the two-year grace period triggers recapture, except for cash leases by surviving spouses to members of the surviving spouse’s family, and, cash leases by a lineal descendant of the decedent to a member of the lineal descendant’s family.

Other Rules

Special use valuation is a complex provision with many requirements that must be satisfied before death, and numerous requirements that the heirs must satisfy for 10-years post-death.  Only those estates comprised of a significant amount of farm land and farm real and personal property that has been owned and operated as a farm for a set amount of time before death is will qualify to make the election.  In addition, the elected land must pass in a prescribed manner to qualified heirs.  Not every person that is typically thought of as a family member counts for purposes of I.R.C. §2032A. 

Conclusion

Special use valuation is a useful tool for some farm and ranch estates where the intent is to continue the farming or ranching business after the death of a family member.  But, if a lease is involved, it must be the right type of lease.  Cash leasing can cause problems.  However, surviving spouses have a special rule that applies to them when it comes to cash leasing land.  They can cash rent to a member or their family.  But, check the rules to make sure that the tenant is actually a member of the family as defined by the statute. 

To restate, special use valuation is a very complex part of the Code.  Today’s post has given only a cursory review of a piece of the statute.