Does Your Farm Owe Estate Tax? A Worksheet You Can Run at the Kitchen Table

Somebody on one stage tells a crowd that the "death tax" is about to wipe out the family farm, and somebody on a different stage tells a different crowd that it never touches a real farmer. Both of them are leaving something out. The estate tax is a tax on the size of what you leave, not on whether you are a farmer, and it rarely applies to a typical household. But farmland is a strange kind of wealth. It can be worth millions on paper while the family that owns it counts its pennies at harvest. That is the family the tax can hurt, and that is the family this worksheet is for.

Here is what you need: a pencil, a calculator, your latest land appraisal or the county's value as a rough guide, your loan statements, and an hour. By the end you will know whether you have a problem worth taking to a lawyer, and what the tools are for dealing with it. This is a planning exercise, not tax advice. The numbers in the example are invented, round and labelled as such. The exemption in the example is a placeholder, not the real number. Congress has changed the figure repeatedly, so look up the current law for the year that matters before you rely on anything here.

How the tax works in four sentences

The federal estate tax is calculated on the total value of what a person owns at death, less debts, expenses and certain deductions. Each person gets an exemption, a dollar amount that passes free of federal estate tax. Anything above it is taxed, and the top rate is 40 percent. Property left to a surviving spouse generally passes free of estate tax thanks to the unlimited marital deduction, and a surviving spouse can often use the unused part of the first spouse's exemption through an election called portability.

Two more things to know up front. Some states have their own estate or inheritance taxes with much lower thresholds, so a family under the federal exemption can still owe state tax. And the federal return, Form 706, is due nine months after death, which is not much time to find money.

The worksheet, step by step

Step 1: List everything you own, at market value

Not what you paid. Not the tax assessor's number, unless you have no better one. What would a willing buyer pay? Include:

• Farmland and pasture, by the acre.
• The farmstead: house, barns, bins and other buildings.
• Machinery and equipment.
• Stored grain and crops in the field.
• Livestock.
• Cash, bank accounts, investments and retirement accounts.
• Life insurance you own on your own life (the proceeds can count in the estate, depending on who owns the policy).
• Anything else of value: vehicles, mineral rights, water rights, a share in a co-op or an LLC.

Mineral and water rights are easy to forget and can be worth a lot. If you are not sure what you own under the surface, read Who Owns the Oil Under Your Farm, and Why America Answers Differently. In the West, the water may be worth more than the dirt, as First in Time, First in Right, and How Western Water Law Really Works explains.

Step 2: Add it up for your gross estate

This is Line A.

Step 3: Subtract debts and expenses

List mortgages, operating loans, equipment loans, unpaid bills and taxes, plus the costs of settling the estate such as funeral costs, legal fees and appraisal fees. This is Line B.

Step 4: Compute your net estate

Line A minus Line B. This is Line C.

Step 5: Subtract the exemption

Look up the exemption for the year of death. In our example below, we will use $10,000,000 per person, an illustration only. If you are married and the first spouse's exemption was not used up, the survivor may be able to add the unused part. If Line C is below the exemption, you likely owe no federal estate tax, and you can skip to Step 8.

Step 6: Apply the rate

For the part above the exemption, multiply by 40 percent. This is a simplification that works when the estate is above the exemption and there are no large lifetime taxable gifts. This is Line D, the estimated federal estate tax.

Step 7: Compare the tax to the cash

Add up the cash and quickly sellable assets the estate has. If Line D is bigger than the cash, you have a liquidity gap, which is where farm families get hurt. The gap is the reason the special rules in Steps 9 and 10 exist.

Step 8: Account for the step-up in basis

When a person dies, the heirs' tax basis in inherited property generally resets to its market value at the date of death. This is the "step-up in basis" under section 1014 of the Internal Revenue Code. It means that gain built up over a lifetime is generally never taxed as income if the heirs sell. That is a large benefit, and it is one reason many families hold land until death rather than give it away (a comparison explored in Four Farm Families, Four Ways to Hand the Land to the Next Generation).

Step 9: Test for special-use valuation

Section 2032A of the Code lets an estate value qualifying farmland at its value as a farm rather than its highest-and-best-use value, which might be a subdivision. That can lower the estate's tax. Broadly, to qualify, a large share of the estate must be farm or business property, the land must pass to a qualified heir, the land must have been used for farming by the family for a required period before death, and the heirs must keep farming it for ten years or risk paying back the savings. The reduction in value is capped at a dollar amount that is adjusted for inflation, so look up the current cap.

Step 10: Test for installment payment

Section 6166 lets an estate that is mostly a closely held business, including a farm, spread the tax over time. The test is that the value of the business interest must exceed 35 percent of the adjusted gross estate. If it does, the executor can elect to pay interest only for the first few years and then pay the tax in annual installments, over up to 14 years in all. The interest rate on part of the deferred tax is reduced. Late payments or a sale of much of the business can accelerate the tax, so the rules need careful handling.

A worked example (hypothetical)

Meet a hypothetical widowed farmer. The numbers are round and invented, the exemption is the $10,000,000 placeholder, and nothing here describes any real person.

First check the land: 1,600 acres times $7,500 is $12,000,000. Then add the six lines: $12,000,000 + $700,000 = $12,700,000; plus $1,500,000 = $14,200,000; plus $600,000 = $14,800,000; plus $300,000 = $15,100,000; plus $250,000 = $15,350,000. Debts and expenses: $1,800,000 + $450,000 + $150,000 = $2,400,000. Net estate: $15,350,000 − $2,400,000 = $12,950,000.

Now the tax. The placeholder exemption is $10,000,000, so the amount over it is $12,950,000 − $10,000,000 = $2,950,000. At 40 percent: $2,950,000 × 0.40 = $1,180,000. That is Line D.

Now the cash test. The estate has $250,000 in cash. The tax is $1,180,000. The liquidity gap is $1,180,000 − $250,000 = $930,000. To pay it, the family would have to sell land, borrow against it, or both. A farm worth nearly thirteen million dollars, net, and the family cannot lay hands on a million in cash. That is the picture of a land-rich, cash-poor estate.

Using the tools on the example

Installment payment (section 6166). The test: the value of the business interest must exceed 35 percent of the adjusted gross estate. The adjusted gross estate here is the gross estate less debts and expenses, which is $12,950,000. Thirty-five percent of that is $12,950,000 × 0.35 = $4,532,500. The farm assets total $15,100,000 (lines 1 through 5), and even after subtracting the $2,250,000 of farm debt, the net farm interest is $15,100,000 − $2,250,000 = $12,850,000. That is far above $4,532,500, so the estate would likely qualify. If the full $1,180,000 were deferred, with interest-only for the first four years and then ten equal annual installments of principal, each principal installment would be $1,180,000 ÷ 10 = $118,000, plus interest. Paying $118,000 a year out of farm income is a very different problem from finding $1,180,000 in nine months.

Special-use valuation (section 2032A). Suppose the farm-use value of the land, under the formula the statute uses, is $4,500 per acre instead of $7,500. Then the land would be worth 1,600 × $4,500 = $7,200,000 instead of $12,000,000, a difference of $4,800,000. But the reduction is capped. Say the cap is $1,400,000 in this example, another placeholder. The estate's value drops by $1,400,000, to $12,950,000 − $1,400,000 = $11,550,000. The amount over the exemption is $1,550,000, and the tax is $1,550,000 × 0.40 = $620,000. The saving is $1,180,000 − $620,000 = $560,000, which is exactly 40 percent of the $1,400,000 reduction. In real life the family must meet the qualification tests and keep farming for ten years.

Step-up in basis. Suppose the family's basis in the land is $1,000,000, because it has been in the family for generations. At death, the heirs' basis becomes the market value, $12,000,000. If the heirs sold the land the next year for $12,000,000, they would have no capital gain from the sale. If instead the farmer had given the land away during life, the heirs would have taken over the old basis, and a sale would produce a gain of $12,000,000 − $1,000,000 = $11,000,000. At a hypothetical 20 percent federal capital gains rate, that gain would carry a tax of $11,000,000 × 0.20 = $2,200,000, before any state tax. The step-up is a powerful offset, and it explains why the estate tax and the capital gains tax have to be considered together.

What changes if the farmer is married

Run the same example a different way. Suppose the same farm belongs to a married couple, and the first spouse dies and leaves everything to the survivor. Because of the unlimited marital deduction, the taxable estate at the first death is zero, and no federal estate tax is due. The family has bought time, not forgiveness: the farm still has to be passed on at the second death.

Here is where portability matters. Say the first spouse used none of the $10,000,000 placeholder exemption. If the executor files a timely estate tax return and makes the portability election, the survivor can add that unused $10,000,000 to the survivor's own, for a combined $20,000,000 in this example. The net estate of $12,950,000 is under $20,000,000, so the second estate would owe nothing: $12,950,000 − $20,000,000 is below zero. Without the election, the survivor has only the single $10,000,000 and the tax is the same $1,180,000 we computed above. The difference between those two outcomes can turn on whether somebody filed a return at the first death, even though no tax was due. That is a sobering reason to talk to an advisor early. Portability rules and deadlines are in the Code and the IRS instructions, so check the current ones.

What the worksheet does not tell you

• It leaves out large lifetime gifts, which can use up part of the exemption.
• It uses a simplified rate calculation.
• It assumes one decedent. For a married couple, the unlimited marital deduction and portability change the picture, and the second death is usually where the tax would arise.
• It does not capture state estate or inheritance taxes.
• It does not account for trusts, life insurance arrangements, business entities, conservation easements or buy-sell agreements, all of which a good advisor will examine.

Those omissions are not small. They are why the next step is a conversation with an estate lawyer and a tax professional who works with farms.

A note on the politics

Why do conservatives argue for repealing or reducing the estate tax? The case is that the assets in a farm estate have already been taxed once, as income, as they were earned and saved, and that taxing them again at death penalizes the saving and the family business. It forces the sale of productive assets to pay a tax bill. The best case on the other side is that a tax on very large inheritances prevents the concentration of dynastic wealth, raises revenue from those best able to pay, and that the exemption is high enough that the great majority of families never pay it. Both arguments are about values, and I will not pretend that a worksheet can settle them. What a worksheet can do is show you whether the argument is about you.

The tax debate also sits inside a bigger fight over the tax code, which you can follow in five changes in the 2017 tax law that reached the kitchen table, where the temporary doubling of the exemption in the 2017 law is one piece. And if you want a sense of why debt and land values can turn on a family so fast, Embargo, Volcker and Foreclosure Is What Really Caused the 1980s Farm Crisis tells the story. For the property-tax side of land ownership, see Sales Tax, Property Tax and Who Really Pays for Your State, and for the myths that keep families from planning at all, read seven tax myths that scare working families and cost them money.

The bottom line

• Run the worksheet before you assume. Most farm families fall below the exemption, but a land-rich family with little cash can find itself above it, and the only way to know is to add it up.
• The danger is liquidity, not just the tax. A tax bill due nine months after death, with the wealth locked up in land, is what forces sales.
• Know the three relief valves. Step-up in basis, special-use valuation under section 2032A and installment payment under section 6166 are all designed for families like yours.
• Check current law and your state's rules. The exemption, the caps and the interest rates change, and some states have their own tax at lower thresholds.
• Take your numbers to an estate lawyer and a tax professional who knows farms. The hour you spend with this worksheet will make that meeting cheaper and far more useful.