Death and taxes: Growing up, I always heard those are the two things that you cannot escape. Many Americans make a living trying to figure out ways to avoid either or both. During the past year and a half, we've all sacrificed and worked hard through a pandemic to reduce the impacts of the first. But for governments, the easiest way to pay for the pandemic challenges is through raising the second.
In the recently proposed American Families Plan, the Biden administration included several potential tax increases. Two proposals are most important to small businesses like farm families and farmland owners. First is the proposed lowering of the federal taxable estate exemption threshold to $3.5 million. And second is the elimination of a stepped-up basis for appreciating assets (such as farmland) at death that are used in their daily business operations.
How might this play out? Proposing a tax on valuation gain (greater than $1 million) during the decedent's ownership period at an effective rate of 39.6%, plus an additional likely 3.8% surtax, could force farmland to be sold to pay inheritance taxes, thus increasing farmland supply to the market. It is possible that certain areas could have an oversupply of land on the market, potentially driving farmland prices lower in those pockets, as a result of tax policy change.
While there are provisions for the taxes to be paid over 15 years, the policy question involves whether a proposal of this nature on an asset that already requires an annual real estate tax also discourages entrepreneurship, family businesses, wealth accumulation and savings.
Another proposed tax code change would eliminate the use of a provision that has been a part of the federal tax code since 1921, known as the like-kind exchange. This allows tax due on the appreciation of an asset to be deferred until it is sold, and not replaced with a similar-type asset.
The example often used in agriculture today is for the practice named after its tax code number, a 1031 exchange. This occurs when farmland near development is sold for its developmental price (very high) and then exchanged into other farmland at the agricultural value (much lower). The provision allows the tax to be deferred (or potentially eliminated when appropriately coordinated with the stepped-up basis mentioned earlier), and allows “progress” to continue in a reasonable manner.
Without the 1031 exchange, sellers would be more reluctant to sell, and it would drive prices of transitional land higher, increasing developmental costs while potentially slowing expansion.
The 1031 exchange has also been an important tool used for years by farm families not experiencing an economic windfall event, but who need to manage through estate divisions, conservation easements and retirement planning.
For example, when farmland is inherited by multiple siblings, but the siblings have separate farming operations, currently, one could buy out the other’s interest in the land, and allow the one selling to their sibling the opportunity to exchange into another tract of farmland without causing a taxable event to occur. This provides buyers to the marketplace at existing price levels, but does not necessarily cause higher prices to rural farmland.
Conservation groups looking to protect farmland habitat for various “good earth” reasons have purchased developmental rights or placed conservation easements on farmland in critical areas. The farmland owner could then take the proceeds from the sales and 1031 like-kind exchange into other farmland they could operate. The provision, in this case, provides additional farmland buyers to meet market supplies. Under current tax proposals, those opportunities would be eliminated as well, and conservation practices and improvements likely diminished.
Farmers typically prefer to create and operate larger tracts of land. The example of selling 80 acres they own several miles away and using the like-kind exchange process to purchase land adjacent to land they own and live on to create a larger, single tract has provided liquidity to the market, and optimized efficiencies in modern agriculture. Without the 1031 exchange, this would be less likely to occur, and the number of potential buyers diminished.
Proposed tax law changes could lead to an increase in farmland supply to the market by this fall if it looks like either of these proposals will be made into law, as landowners weigh their options over the summer to potentially lock in the current capital gains tax rates. Consulting with knowledgeable estate planning attorneys, accountants and real estate professionals to develop a plan to minimize the impacts of these changes could be time well spent over the summer.
Klein is vice president at First Mid Ag Services, Bloomington, Ill., and is a member of the Illinois Society of Professional Farm Managers and Rural Appraisers. Email questions to [email protected]. The opinions of this writer are not necessarily those of Farm Progress/Informa.