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Know your farm’s cost basis and how it relates to changes in basis step-up

Getty/AlenaMozhjer Aerial view of farmstead and fields during growing season.
Become familiar with your farm’s cost basis to determine the potential transfer tax to your heirs.

By now I think most are aware of the potential tax law proposals which could threaten the successful transfer of your family farm. In particular, the new proposed transfer tax if passed, would be the first time in history our government will impose a tax to inherit appreciated assets.

Basis step up

One misconception is this new proposal will remove basis step up. Basis step will actually stay in-tact, it’s just now there could be a recognition of the capital gain. In other words, step up in basis would no longer be “free” -- we may have to “pay” for it. 

One of the first steps in determining this new transfer tax is knowing your farm’s cost basis.

I recently met with a family and their tax advisor estimated this new transfer tax to be $750,000 for the heirs to inherit their 300-acre family farm. The calculation looked like this: $3,600,000 fair market value less $1,100,000 cost basis = $2,500,000 capital gain. The tax proposal states the first $1 million of gain per individual is exempt which reduces the taxable gain from Mom’s estate to $1,500,000. The tax advisor estimated a tax rate of near 50% between federal and state capital gains, or a $750,000 transfer tax the heirs would have to recognize to inherit the farm.

This new tax will lead to an entirely new set of concerns for many families if it comes to fruition. We won’t go into great detail about those in this post, but you may want to reference a previous post: 4 estate planning choices to consider before year-end.

Know your cost basis

What motivated the idea for today’s post is the challenge the above family had in actually determining the cost basis for their farm. The origination for some of the farm’s basis goes back to 1951 when the farm was first purchased, but also required tracing through multiple years of gifting from Mom and Dad to the kids as well as a portion of the farm receiving a new basis upon Dad’s passing in the 1970s. They and their tax advisors finally determined the average basis to be $1,100,000 as used in the calculation above. 

Knowing your cost basis is not only an important part of this calculation, but also good to know for understanding some of the strategies we use in transition planning. 

For one, gifting. Some are considering gifting assets now while they have a large lifetime exemption of $11.7 million to gift away, tax free. Current proposals could reduce this to as low as $1 million for lifetime gifts. This is the “use it now before you lose it” mentality.

When you gift assets, you also gift its current basis, which is called carryover basis. 

Another strategy some are considering is selling assets now, either as a lump sum or via an installment sale while capital gain rates are historically low. An installment sale on farmland allows the seller to spread any capital gain over the term of the contract. In order to calculate the capital gain you must first know your current basis.

And yet another strategy is in the form of a part sale-part gift. The part sale is in the form of an installment sale in order to maintain an income source during retirement via the annual land payments. The part gift is discounting the sale price of the farm to its cost basis. This eliminates any capital gain so there is no tax on the sale of the farm. It is also a potential strategy for gifting a good portion of your equity now to avoid the above transfer tax inheritance later.

All of these require an understanding of your cost basis and what level of capital gain you are trying to manage. This may seem trivial, but more times than not it takes more legwork than you may expect to find and verify this information. Doing so now will better position you and your family to make better decisions later.

If it turns out no changes to tax policy are made, don’t worry, this won’t be a wasted exercise as this is valuable information to pass along with the farm to the next generation. 

Would you like to learn more about the new tax law proposals and how you can prepare for them as a farmer or landowner? We will be hosting a one-hour Zoom videoconference on Friday, Sept. 3 at 11 a.m. All are welcome and you may RSVP at www.nextgenag.us or by emailing me directly at [email protected].

Downey has been helping farmers and landowners for the last 21 years with their family farm transition, leasing strategies, finances, and general land consultation.  He is the co-owner of Next Gen Ag Advocates and an associate of Farm Financial Strategies

The opinions of the author are not necessarily those of Farm Futures or Farm Progress. 

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