One challenge faced by high-net-worth farmers and ranchers is the increasing value of their estate. Inflation creates the problem. What can families do now that their land has appreciated so much?

Many agricultural families started decades ago with very little, worked hard, lived frugally, and saved by reinvesting every spare dollar in mortgage reduction and land acquisition. Then, if everything went reasonably well, they rather suddenly found themselves sitting on hundreds or thousands of acres of debt-free and appreciating real estate.

With land prices around the West continuing to grow, is there anything that can be done? Using the gift tax exclusion of $15,000 per year, a married couple can each give a few acres annually to each of their children. But with 1,500 acres of appreciating real estate, they cannot give it away fast enough to make a dent.

If you are facing this situation, consider implementing some “discounting” strategies. You can form a limited partnership and deed a portion of your land to the partnership. The terms of the partnership prohibit transfer of the assets outside of the family. Although the partnership now owns the land appraised at $5 million, an appraiser determines that each 1% of the partnership is only worth $32,500. This effectively reduces the value of that land to $3.25 million.

Trust value

To build on the strategy, you can create a special type of trust for your children. You make a cash gift of $250,000 to the trust. This trust will not be included in your or your spouse’s estate. It will also not be included in the future estates of your children and descendants. You then sell 98% of the limited partnership in exchange for $250,000, plus a promissory note of $3 million. The note bears interest at 4%.

The trust, owning 98% of the partnership, has to pay $175,000 per year back to you for about 30 years. If you die before it is paid off, the note remains a part of your estate, which will pass to your children.

Ninety-eight percent of the net income from the land would be payable to the trust … which uses the money to pay the note. There is no capital gain on the sale or income tax on the interest payments back to you. The income remains taxable to you, much as it was before the transaction. If there is extra income, it remains in the trust, insulated from estate and gift taxes forever. The terms of the trust may permit distributions of income and principal to your descendants at the discretion of the trustee, as needed.

Fast-forward 15 years. Instead of you having a taxable estate that has grown to $10 million, you own only 2% of the partnership and the remaining balance of the promissory note — which is less than $2 million. You would still own your home outside of the partnership; and to the extent you haven’t been spending all of your $175,000 annual payments, you would be growing a savings account!

By looking ahead and attacking your “growing” problem, you have effectively discounted and frozen the value of your estate at around $3.25 million, and limited the growth to the 4% you receive in interest. Even if land prices had gone flat, instead of a $5 million estate, your taxable estate is around $3 million, and all of the land is protected in the trust, which is perpetually free of death taxes. Remember, you may not be subject to death taxation today, but taxation is extremely likely to increase in the future.

As is so often the case, this is an overly simplified illustration. These techniques are very numbers-driven, and the effectiveness and appropriateness of the approach for a particular family is dependent on its specific situation.

The true complexities underlying estate-freeze planning are mind-boggling. You should embark on such planning only with an experienced professional adviser, taking into account your specific asset and income situation and — most importantly — your unique family goals, challenges and issues.

With thanks to Curt Ferguson, who contributed to this column, Dolan, an attorney, helps farm and ranch families achieve comprehensive estate, succession and legacy planning objectives. Dolan is the principal of Dolan & Associates, P.C. in Brighton and Westminster, Colo. Learn more at his website, estateplansthatwork.com.