As you find yourself ready to slow down a bit, you may be considering your options for transitioning the farm. Perhaps your children are ready to take over running the farm. You’ll need to decide whether to gift them portions of the farm or if you need cash flows from a sale or rental of the land. Or maybe you and your children are considering selling the farm to someone outside the family. You then need to decide whether to live on the farm and rent the fields to others or to sell your home and move into town.
Farm owners today face a complex set of decisions as they plan for retirement. They need to balance transitioning the ownership and operation of their farms with maximizing compensation for their years of labor. Many have not evaluated the sources of income in retirement to ensure their current and future needs will be met. They also need to think about when and how their estates will transfer to their heirs.
We work with farmers to evaluate future scenarios for their families and businesses. As we chart a course for a comfortable retirement, we also aim to shield hard-earned assets from inheritance taxes.
Estate Planning Strategies for Farmers
Married couples can establish and fund trusts to transfer $10,980,000 in net assets to their beneficiaries free of federal taxes. The IRS tax code provides a few provisions to allow for special valuations of farm property. Once the $10+ million limit has been met, however, a 40% federal estate tax takes effect.
Oregon supports a much lower estate tax threshold. The state Department of Revenue allows a married couple with a trust to exclude $2 million from taxation. As with the federal tax code, there are a few special credits for farmers to help reduce inheritance taxes under certain conditions. If the fair market value of your equity in the farm exceeds the federal or state thresholds when it is passed down, these strategies can help cut taxes.
Gifting Assets to Your Children
A long-standing estate planning technique involves making annual gifts to your heirs. The IRS allows for a person-to-person $14,000 annual gift without filing a gift tax return. This means married farm owners could gift up to $56,000 annually to their married offspring. The total amount breaks down to $14,000 gifts from each parent to their son or daughter and an extra $14,000 each to their son or daughter-in-law. Gifts over the $14,000 person-to-person limit are permissible but require filing a gift tax return. However, no tax is due until the donor uses up the lifetime exemption.
Large estates might need a more substantive transfer mechanism to avoid future estate taxes. Another option is for farm owners to transfer assets as gifts to Limited Liability Corporations (LLC). Their heirs can then be declared the owners. The assets are valued at the prevailing market rates upon transfer, and subsequent gains remain outside the purview of the donors’ estate. This strategy is particularly beneficial for a family farm where the heirs plan to continue farming and the market value of the farmland is expected to rise.
But what if your heirs don’t want to work the farm and plan to cash out of their inheritance? These circumstances call for a bit more number-crunching. While gifts shield the estate from inheritance taxes associated with asset appreciation, they deny the heirs a stepped-up basis for the property at the time of the original owner’s death. The basis remains at its original level, which could be a very low number for long-held properties. The heirs could wind up with substantial capital gains liability upon the sale of the property.
Take, for example, Joe Smith who owns a farm with a current market value of $5 million and a cost basis of $500,000. While his estate falls below the federal limit, he knows his heirs will face the Oregon inheritance tax. He also knows neither of his two children plans to work the land after his passing.
If Joe holds all the assets in his own name until his death, his $5 million estate will avoid federal taxes and receive a $1 million exemption from the state of Oregon, leaving a net valuation of $4 million. The Oregon inheritance tax will equal $425,000 before special farm credits. The basis of the property will step up to $5 million, leaving little to no capital gains exposure should the children liquidate it shortly thereafter.
If Joe transfers assets to the LLC, he can avoid inheritance taxes. However, the basis of the property would remain $500,000 upon his death. At the sale, the heirs would owe roughly $865,080 in federal capital gains tax and $225,000 in Oregon capital gains taxes for the complete liquidation of farming activities. In this case, a $425,000 inheritance tax bill is far preferable to a $1,090,080 capital gains assessment.
Selling the Farm
What if you want to move into town but keep the farmland in your name to receive the step up in the tax basis? Consider selling the house to your heirs and exclude up to $500,000 of capital gains relating to the sale of your home. The next generation could then move on site and rent the farmland from you.
Let us help you with these very important calculations based on your individual circumstances. A custom-tailored plan can create a smooth transition based on your needs and your family’s long-term plans.
Meet the Author
Joanne Humphrey, CPA, PFS
Joanne has over 30 years of experience providing business advisory and tax services for business owners with special expertise in dental and medical practices. This includes complex tax preparation and planning, trust and estate planning, retirement planning and financial planning for small and large practices. Joanne specializes in analysis of retirement plan design, ensuring maximum…
- Wealth management
- Personal Financial Specialist
- Certified Public Accountant
- Tax compliance and strategic tax planning
- Preparation, analysis, and review retirement plan returns and investment reports