The current COVID-19 crisis has created an extraordinary window of opportunity for farm families that probably will disappoint some politicians. Two factors are in play: depressed land prices and unbelievably low interest rates. If you have an estate that is large enough to incur estate taxes (larger than the $4 million Illinois estate tax exemption), and you want to avoid those taxes, now is the time to act.
Real estate appraisers say a decline in land values is imminent. This makes sense given the challenges farmers are facing. The decline — temporary, we hope, of course — should be showing up over the next few months. If you have 500 acres to remove from your taxable estate, it is much easier if an appraiser can certify at the time of the transfer that those acres are worth $10,000 instead of $12,000.
The impact of interest rates, however, is less obvious to those outside of the estate planning profession. Each month the IRS publishes applicable interest rates, effectively setting the minimum rate you must charge if you are involved in a family transaction. For a long-term loan (more than nine years) in June 2020, you must charge at least 1.01% annual percentage rate. The applicable rate for shorter-term loans is even lower. Several of the strategies used to move assets from one generation to the next, while the first generation is living, are sensitive to interest rates.
If you have 500 acres of $10,000-per-acre land to transfer to heirs and you simply give it to them, you just made a $5 million gift, which reduces the amount you can leave them tax-free when you die. There was no strategy and no leverage. You also gave up all cash flow from that land.
If you sold the land to them, you could finance the sale over 20 or more years and only charge them 1.01% interest. While that is kinder than having to charge them 4.3%, as you would have 10 years ago, there are still problems: You will have to pay capital gains tax on the sale, the heir can’t afford to pay the $5 million, and your estate still will be owed a lot of that money at your death. Your child is better off to buy land from a neighbor and wait to inherit yours!
A compromise might be to give the child 200 acres and sell him or her 300 acres. You still would recognize taxable gain on the sale and would have to report the $2 million as a gift. Also, you still have $3 million — the amount the child owes you or has paid you at any given time — in your estate to be taxed at death. This compromise achieved very little.
Strategic planning involves transferring more value than you must report as a gift.
Let’s say instead, at 66 years of age, you establish a trust for your heirs and transfer the 500 acres to that trust in exchange for a payment of $150,000 per year for the rest of your life. Indirectly, you are retaining the income from the 500 acres. What is the present value of $150,000 per year for life? Under the current IRS interest rates, it’s $2,394,000. That value is deducted from the land you transferred, so while $5 million has been removed from your estate, you only report a gift of $2,606,000, or 52% of the value you transferred. With current estate and gift tax exemptions, scale that up, and you could remove over $22 million from your estate this way, tax-free. Double that for a married couple. Merge the strategy with other techniques, and you could move 25% to 40% more.
What is the big deal about timing and interest rates? Ten years ago, when the IRS long-term interest rate was 4.3%, the value of your $150,000 life payments would have been $1,813,000, so your gift would have been much larger: $3,187,000. Twenty years ago, with the interest rate above 6%, the gift would have been $3,774,000. Today, the gift reported is only 52% of the property value, whereas in 2010 the gift was valued at 64%, and in 2000, the gift was 75%. The low interest rates provide greater leverage and allow you to transfer much more property tax-free.
Of all the topics I write about, this is one that requires great caution. It is tried and true, but there are many details that must be done correctly for it to pass IRS’ muster. It is essential that you seek and follow experienced professional advice.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com. The opinions of this writer are not necessarily those of Farm Progress/Informa.