Everyone wants to know what they should do about the looming changes to tax policy. The problem is no one knows exactly what they are yet, but most agree changes are indeed coming. We encourage you to get comfortable knowing your options and mentally prepare yourself to make important decisions later this year, if needed.
Here are 4 choices to consider:
- Do nothing and outlive it
- Do nothing and accept taxes
- Transfer assets now to avoid taxes later
- Be prepared and buy an option
Let’s make the following assumptions:
- Estate tax exemptions will decrease while effective tax rates increase
- Lifetime maximum gifts (tax free) will now be capped at $1 million
- A new recognition of capital gains will be imposed on transfer of assets by gift, sale, or inheritance
- All of these changes will be effective January 1, 2022 (not retroactive)
Related: Mike Downey will be speaking at Farm Futures Summit. Learn more at the Farm Futures Summit website.
Outlive the current regime
I met with a 70-year-old farm couple last week who said even if all of the above tax laws are passed they plan to outlive Biden and the current administration. They plan to do nothing and take their chances the tax laws will revert back again. This is one option.
Do nothing and pay the tax
A second option is do nothing and accept we all need to do our part and pay taxes. A recent analysis from the University of Illinois farmdoc estimated 50% to 70% of Illinois grain farms would incur a tax liability from the new proposed transfer tax. This tax could range from $1,000 to $5,000 per acre and exceed $500,000 for many family farms. The tax advisor for one family I work with estimated this transfer tax to be $670,000 on their 260-acre farm. This farm family is asset rich, but cash poor and their estate will not have enough liquidity to pay this tax.
The heirs could pay this tax or leverage against the inherited land and borrow the funds needed to pay the tax. This equates to an annual payment of over $200 per acre with traditional financing. It will essentially take all the net rental income from the farmland to service the debt which some of the heirs may not be thrilled about. This will no doubt put pressure on many family farm transitions to liquidate parcels of land to pay this new transfer tax.
Transfer assets now
A third option is to transfer assets now in order to remove equity from your estate subject to the new tax laws (assuming they are not made retroactive). The current lifetime estate tax exemption is $11.7 million per person ($23.4 million per married couple) which is not only your death tax exclusion, but also the amount you can gift away during your lifetime, tax free. New tax proposals would bring the death tax exclusion down to $3.5 million per person and the gift tax exclusion to $1 million per person.
Transfers by gift: One family I work with has a $20 million estate and will potentially go from owing zero tax under current law to $11 million under the new proposed laws ($6.5 million of estate tax plus $4.5 million income tax recognition on capital gains). They are mentally preparing to make a large gift later this year once the details of the new tax changes are clearer. In an extreme example, they could gift the entire $20 million of equity to their kids now, tax free.
Transfers by part sale-part gift: Another family I am working with is mentally preparing to sell the farm to their kids toward the end of the year. Why would the kids buy the farm they stand to inherit anyway? Because the potential transfer tax on the capital gains would force them to liquidate some of the land which they all want to avoid. The part gift in this strategy is to discount the purchase price to the land’s cost basis. This transfers most of the equity from Mom and Dad to the kids now, tax free, and now there is no capital gain subject to the new transfer tax. The part sale is in the form of an installment contract where Mom and Dad receive an annual payment equivalent to what their net land rent was in order to maintain their income during retirement.
Tip: Before transferring assets, strongly consider a management structure to help facilitate leasing and purchases between children. Both of the strategies above could also be done with a land entity such as a limited liability company or a trust. These can define permitted landowners to be lineal descendants if it’s important to keep the farm together and in the family.
Buy an option
One last choice is to buy an option, or in other words, insure it. The family above who faced a $670,000 transfer tax is purchasing an equivalent value life insurance policy on Mom and Dad. Mom and Dad aren’t excited about gifting or selling the farm, and the kids would rather borrow money to buy more land rather than pay tax. Instead of a $200 per acre bank payment, they are choosing a $40 to $65 per acre insurance premium now (depending on insurability). The farming son compared it to buying a put or a call for price insurance on their grain. In this case, the insurance premium is a $.05 to $.07 per bushel option to provide the liquidity needed to address future transfer taxes.
As with any important decision for your family farm, please consult with your legal advisors who are most familiar with the details of your situation. Please consider starting these conversations now to get mentally prepared for making important decisions later this year.