Monday, May 24, 2021
For federal estate tax purposes, valuation is typically the primary issue. Quite often, there are more dollars at stake with respect to the valuation issue than with respect to all other issues combined. As such, the facts of a particular case concerning valuation may be more important than applicable law and IRS rulings.
What if ag land has an environmental issue associated with it? Such things as the presence of hazardous materials and wetlands can have a significant impact on land value. But, what is the degree of the impact on value, and how is it measured?
Valuing ag land with environmental concerns – it’s the topic of today’s post.
When valuing agricultural land, it is important to preserve all contemporaneous data applicable to the decedent’s estate. This includes creating a checklist of assets requiring action by others as to evaluation. The checklist should include appraisals, environmental land-use restrictions recorded in the real estate records; environmental audits; and assessment figures for property tax purposes.
If a decedent’s estate contains contaminated real estate, or real estate subject to use restrictions, the estate executor will need to justify a reduction in value for estate tax purposes. That will require sufficient proof of the existence of contamination and any associated land use restrictions as of the date of the decedent’s death and the effect on the land’s value.
Note: Property valuation is also important during the landowner’s life for purposes of gift taxes, property taxes, or to establish a selling price. The issue is complicated by the fact that the effect of contamination on value, like other elements influencing valuation is frequently more subjective than it is tangible and quantifiable.
Two of the big ways that environmental constraints can impact the value of agricultural land involve hazardous materials and wetlands.
Hazardous chemicals/waste. Farms and ranches use various chemicals in the process of raising crops and livestock and operating machinery and equipment. It was not uncommon in the past for a farm or ranch to have a dump site on the premises. Various hazardous substances could be present at those sites. When hazardous chemicals are present, they will increase the cost of owning the property in terms of monitoring and cleanup costs as well as potential legal liability.
In recent years, the IRS has been all over the board on whether cleanup costs are currently deductible or must be capitalized. In short, the answer depends on whether the taxpayer created the mess that is being cleaned up or is cleaning up someone else’s mess. In a 2004 ruling, a corporation in the business of manufacturing products that it placed in inventory was required by state and federal law to clean up the soil and water contaminated by hazardous waste that the corporation had disposed of at the site. The IRS ruled that the soil and groundwater mediation costs had to be capitalized into the costs of the products that the corporation produced. Rev. Rul. 2004-18, 2004-1 C.B. 509. In 2005, the IRS extended the ruling by concluding that environmental remediation costs are more in the nature of repairs than capital improvements and are allocable to the inventory produced in the tax year during which the costs are incurred. Rev. Rul. 2005-42, 2005-2 C.B. 67.
Note: Because costs incurred to clean up environmentally contaminated property may involve a pre-existing material condition or defect, the tangible property regulations could come into play. In such event, remediation costs may be treated as a betterment because they ameliorated a material condition or defect in existence before the taxpayer bought the property, which would require the costs to be capitalized. Capitalization could have a particularly harsh effect on individual landowners, who may be less capable of sustaining a large outlay for cleanup costs without an offsetting deduction. Also, if the property is held merely as an investment and not as part of the landowner’s trade or business, the landowner will be subject to the passive loss rules. Thus, even if the remediation costs are deductible, costs in excess of income from the property may offset only other passive income that the landowner may have. See I.R.C. §469.
The presence of hazardous chemicals/waste will also make the property less desirable in the marketplace.
Wetlands. Wetland laws and regulations restrict land use and may cause the land to be unmarketable and, perhaps, worthless because of the loss of value to the particular property owner. If the restriction eliminates all of the economic value of the property without a federal permit, some court’s have held that a governmental taking has occurred. For example, in 2014, the United States Court of Federal Claims held that the denial of a CWA §404 permit constituted a taking. Lost Tree Village Corporation v. United States, 115 Fed. Cl. 219 (2014), aff’d., 787 F.3d 1111 (Fed. Cir. 2015). Under the facts of the case, the landowner bought the tract at issue as part of a transaction in which the landowner purchased an entire peninsula on which the tract was located. The landowner developed the other land into a gated community and did not treat the tract as part of the same economic unit, but later decided to develop the tract. In order to develop the tract, the landowner needed to acquire a Clean Water Act Section 404 permit. The permit was denied, and the landowner sued for a constitutional taking. Initially, the U.S. Court of Federal Claims determined that a constitutional taking had occurred and that the relevant parcel against which to measure the impact of the permit denial was the tract plus a nearby lot and scattered wetlands located nearby that the landowner owned. On appeal, the U.S. Court of Appeals for the Federal Circuit held that the tract was the relevant parcel. On remand, the Court of Federal Claims, held that the loss of value caused by the permit denial was 99.4 percent of the tract's value, or $4,217,888 based on the difference in the tract's value before and after the permit denial. The court rejected the government's argument that the "before valuation" must account for the permit denial. The court said that the government cannot lower the tract's value by arguing the possibility of the permit denial.
The presence of a wetland on tract can also trigger a reduction in the land’s assessed value for property tax purposes. In a significant case from New Jersey, the New Jersey Superior Court upheld a state tax court decision that reduced a property tax assessment from nearly $20 million to $976,500. Bergen County Associates v. Borough of East Rutherford, 265 N.J. Super. 1, 625 A.2d 524 (1993), certification den., 134 N.J. 482, 634 A.2d 528 (1993). The court found persuasive testimony that indicated that the application process for permits to dredge and fill wetlands had become “much stricter” in the late 1980s, and were “virtually impossible to obtain.” It is important to note that the taxpayer was not denied a permit to fill the property. Instead, the taxpayer went directly to court to argue for a substantial assessed valuation reduction based on the land use restrictions.
On the property tax valuation issue, as long as the property has a value in use (e.g., it is producing income), a lack of marketability will not support a claim for lack of value. However, the IRS Examination Technique Handbook for Estate Tax Examiners instructs IRS estate and gift tax examiners to consult assessment records as good sources of information for estate and gift tax values.
IRS test. The IRS test for valuation is the “willing-buyer/willing-seller” test. Treas. Reg. §§20.2031-1(b); 25.2512-1. For estate (and gift) tax purposes, property must be valued at its fair market value as of the valuation date in accordance with the IRS test. The test necessarily focuses on the marketability of any particular property. But, there is value in use that is separate from marketability. Value in use focuses on value to the particular owner of the property.
Consider the following example:
Kenny Dewitt owns a farm that produces an income stream (net of expenses) of $350,000 per year in harvested crops. Assume that the farm normally would has a capitalization rate of four percent (typical for cropland), producing a “clean” value of $875,000. Due to contamination from leaking underground storage tanks and nitrate contamination of groundwater, the property is neither marketable nor mortgageable, leaving the equity yield (which is generally higher than the cost of debt financing) the primary component of the capitalization rate. In addition, a higher return on equity will be demanded to reflect the additional risk of holding contaminated property and its lack of marketability. As a result, the capitalization rate could easily become eight percent, which decreases the value of the property by 50 percent to $437,500. After this value is calculated, the costs of cleaning up the property still will have to be taken into account.
Note: It’s probably overly simplistic to determine the “clean value” of a property and then subtract the cost of cleanup. Additional factors such as contingent liabilities to the public and stigmatization may affect value to at least the same extent as the actual remediation costs.
Stigma. A physical cleanup of a tract does not eliminate the loss of value resulting from stigmatization. Even when property has been cleaned up to the satisfaction of the state and federal government, potential buyers tend to remain reluctant, making the property less desirable in the marketplace. Additionally, if interested buyers can be found, lenders may be reluctant to finance the acquisition of contaminated or potentially contaminated property. That could make financing the property more costly. That, in turn, can impact market value. Thus, it’s safe to say that external environmental factors can influence market value.
Buying agricultural land often is fairly straightforward. However, when environmental factors are present determining fair market value takes on a completely different twist.