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What Is Special Use Valuation?

If you own a farm or closely held business, special use valuation can be a powerful post-mortem (after death) estate planning tool that your personal representative can elect to use to help minimize federal estate tax if they have been imposed on your estate. When you die, your estate may be subject to federal generation-skipping transfer (GST) tax and/or federal gift and estate tax (collectively referred to here as "estate taxes"). (Note: State death taxes may also be imposed). Generally, for estate tax purposes, property in your estate is valued at its fair market value (FMV). FMV means the price at which property would change hands between a willing buyer and a willing seller or what it would sell for on the open market.

This value represents the property's highest and best use. If your estate qualifies, special use valuation values real property (e.g., real estate) used for farming or in a closely held business based on its actual use rather than its highest and best use. This lower valuation results in reducing your taxable estate and may result in reducing any estate taxes that may be owed. Special use valuation can help heirs avoid having to sell the farm or business just to pay estate taxes. However, the special use valuation election can be lost under certain conditions. Under the recapture rule, the IRS will recalculate (recapture) the estate taxes due using the FMV if, within the 10 years following your death, the property in question is disposed of or ceases to be used for the originally qualified use.

Caution: The IRS may pay close attention if special use valuation is used. Your personal representative should take care that all qualifications and technical requirements are fully satisfied.

Caution: There is a limit imposed on how much the special use valuation method can reduce your taxable estate. Your taxable estate can't be reduced by more than a certain amount ($1,180,00 in 2020, $1,160,000 in 2019).

Tip: Because of the recapture rule, special use valuation should only be elected if your real property is expected to remain in the family farm or business.

Tip: Special use valuation may be especially useful when your property has not kept up with the price of surrounding property (e.g., a farm around which high-priced homes have been developed).

Does Your Estate Qualify?

To qualify for special use valuation, all of the following requirements must be satisfied:

You Must Be a U.S. Citizen or Resident at the Time of Your Death

You must be a U.S. citizen or resident at the time of your death.

The Property Must Be Qualified Real Property

Qualified real property is property that is located in the United States and owned by you and/or an immediate family member, either directly or indirectly (e.g., interests in a trust, partnership, or corporation), on the date of your death, and for periods totaling at least five of the eight years preceding your death. You or a family member must have materially participated in the farm or small business during this time for at least five of the eight years preceding your death.

Technical Note: It is possible to qualify for special use valuation when you own the qualified real property through a partnership, corporation, or similar entity. In such a case, special rules apply to determine what portion of the entity you own and whether you have actively participated. Family attribution rules may also apply to treat interests held by certain family members as if they were held by you.

The Property Must Have Been Used for a Qualified Use

The property must have been used as a farm or in a closely held business by you and/or an immediate family member on the date of your death and for periods totaling at least five of the eight years preceding your death.

Technical Note: A farm for special use valuation purposes includes nearly any agricultural or grazing use and is defined as livestock, dairy, poultry, fruit, fur-bearing animals, plantations, ranches, nurseries, orchards, ranges, greenhouses, and certain woodlands (standing timber). A closely held business applies only to an active business such as a manufacturing, mercantile, or service enterprise.

You Must Give the Property to a Qualified Heir

A qualified heir is an immediate family member. Family members include your spouse, your ancestors, your lineal descendants, your parent's descendants, your spouse's descendants, and the spouse of your lineal descendants.

You or an Immediate Family Member Must Have Materially Participated In the Farm or Closely Held Business

You or an immediate family member must have materially participated in the farm or closely held business operation for an aggregate of five years or more of the eight-year period ending on the earlier of the date of your death, the date you became disabled, or the date you first began receiving Social Security retirement benefits.

Technical Note: Material participation is a legal term. It can be satisfied by physical work or by participation in management decisions on a day-to-day basis.

Your Estate Must Pass Certain Percentage Tests

Your estate must pass two percentage tests:

  • The adjusted value of the property's assets (gross value less debts and unpaid mortgages) must equal at least 50 percent of your adjusted gross estate (gross estate less debts and unpaid mortgages)
  • At least 25 percent of your adjusted gross estate (gross estate less debts and unpaid mortgages) must consist of farmland or closely held real property

Example(s): Jake's estate includes a bakery, Jake's Cakes. Jake's gross taxable estate, including the bakery, is valued at $1 million. The estate's unpaid mortgages and debts equal $400,000. The adjusted gross estate is $600,000 ($1 million - $400,000). Fifty percent of the adjusted gross estate is $300,000, and 25 percent of the adjusted gross estate is $150,000. The value of Jake's Cakes is $700,000 ($500,000 real property and $200,000 equipment and other property). The mortgage on Jake's Cakes is $250,000. Jake's estate passes both percentage tests as follows:

  • The value of Jake's Cakes less unpaid mortgages is $450,000 ($700,000 - $250,000); the $450,000 exceeds 50 percent of Jake's adjusted gross estate ($300,000)
  • The value of Jake's Cakes real property less unpaid mortgages is $250,000 ($500,000 - $250,000); the $250,000 exceeds 25 percent of Jake's adjusted gross estate ($150,000)

Tip: The special use valuation and percentage rules are complex. You should seek the advice of a tax attorney and arrange your estate as early as possible to qualify if you plan on the special use valuation election. For example, you may need to reduce the value of your gross estate (e.g., by making lifetime gifts) or increase the value of qualified real property that you own (e.g., by acquiring additional real property) in order to meet the percentage tests.

How Does Your Personal Representative Make The Election?

To satisfy the technical requirements, your personal representative must complete all of the following:

Complete form 706 and Schedule A-1

  • Check the appropriate box on the estate tax return (Form 706) — The election for special use valuation is made by checking the box on the estate tax return Form 706. Your personal representative must make the election on the first estate tax return that is filed. The election can be made on a late-filed return, as long as it is the first return to be filed. Elections made on subsequent returns will not be valid (subsequent returns may be filed if an adjustment is needed). Once special use valuation is used, the election is irrevocable.
  • Complete Schedule A-1 and attachments — Your personal representative must also complete Schedule A-1 and the required statements. Schedule A-1 and attachments must be filed with Form 706 in order for the election to be valid.

Tip: If your estate doesn't appear to satisfy the requirements to qualify for the special use valuation method, your personal representative should make a protective election anyway. This way, if it is later determined that the requirements are satisfied after all, the subsequent election will not be denied because it is untimely. Making a protective election doesn't mean that special use valuation must be used. The election becomes irrevocable only if the method is actually used. A protective election is made by completing the appropriate line of Form 706 and by checking and completing Protective Election, Schedule A-1.

Attach a Signed Recapture Agreement

Because the tax saved by using special use valuation is subject to recapture under certain conditions, a recapture agreement must be attached to the estate tax return (Form 706). The recapture agreement must: (1) list the names of each qualified heir, his or her address, identification number, relationship to you (the decedent), and both the FMV and the special use value of the property received; and (2) be signed by each heir who receives an interest in the property.

Tip: You may be able to satisfy this requirement by completing Schedule A-1. However, if there is not enough room for all the information, a separate agreement must be attached.

Attach a Formal Appraisal

Your personal representative must file a formal appraisal of the property with the estate tax return if special use valuation is used. An expert appraiser can be found through the yellow pages or by seeking referrals from banks, financial planners, or real estate brokers. Be sure to check the appraiser's credentials for experience in valuing property for estate tax purposes.

Timely File the Estate Tax Return

Your estate tax return (Form 706) and attachments must be filed in a timely manner (i.e., nine months after your death unless an extension has been granted). An untimely filing may result in the IRS rejecting the election. If your personal representative makes a timely election but fails to provide complete information or necessary signatures, your personal representative will have a 90-day grace period after being notified by the IRS to provide the missing information or signatures.

How Is Qualified Property Valued?

Valuing Closely Held Business Real Property

The value of closely held business real property is determined using the multiple-factor method. Under the multiple-factor method, the special use value of real property is determined by considering factors such as the following:

  • The fair rental value of the property (as closely held business property)
  • Assessed property values (if local assessment law takes into account the use of the property)
  • Income or yield that can be expected over a given period of time
  • Comparable sales of property in the same area
  • Any other factor that fairly values the property

Because this method of valuation is subjective, your personal representative must take care to weigh each of the pertinent factors according to the facts and circumstances of your estate to arrive at a reasonable value. Your personal representative cannot select a single factor as the only basis for the valuation, so it may be best to instruct your personal representative to be conservative.

Valuing Farmland

Your personal representative can elect to use one of the following three methods to value farmland:

  • Capitalization method — The capitalization method compares your property to other comparable properties located near you.

Comparable property is a factual determination. Some of the factors that may indicate that two properties are comparable include:

  1. Similarity of soil
  2. Types of soil conservation practiced
  3. The slope of the land
  4. Whether the properties are subject to flooding
  5. In the case of livestock, the carrying capacity of the land
  6. In the case of standing timber, whether the timber is comparable
  7. Whether the soil is depleted at the same rate or in the same manner
  8. Whether the property is unified or segmented
  9. The proximity and access to local markets

10.The number, types, and condition of buildings or other improvements on the land

The capitalization method is most easily explained by the following formula: (Average annual gross cash rental per acre - Average annual state and local real estate taxes) ÷ Average annual effective interest rate on Federal land bank loans = Per acre value. The average annual gross cash value is the average gross amount of cash received per acre for the use of comparable property in the vicinity of your property. The average is computed on the receipts over the five years preceding your death. The average annual state and local real estate taxes are the average per acre amount of state and local taxes imposed on the comparable property for the five years preceding your death. The average annual effective interest rate is the average annual billing rate charged under the Federal Credit Bank system for loans to other farmers and ranchers in your area.

Example(s): Jill owned a 300-acre dairy farm in Wisconsin at the time of her death in 2019. A comparable 350-acre dairy farm in the next county had received cash rental income during the period from 2014 through 2018 as follows:

Year

Gross Rental

Property Taxes

Net Rental

2014

$105,000

$26,000

$79,000

2015

107,500

26,150

81,350

2016

111,125

28,225

82,900

2017

115,700

29,900

85,800

2018

121,200

31,600

89,600

TOTAL

560,525

141,875

418,650

Annual Average

$112,105

$28,375

$83,730

Average Per Acre

$320.30

$81.07

$239.23

Example(s): The average annual effective interest rate for property in Wisconsin for 2019 is 4.68 percent.

Example(s): If Jill's personal representative elects special use valuation for the farm, the value is $1,533,516 computed as follows:

Example(s): (average annual gross cash rental per acre - average annual state and local real estate taxes) ÷ average annual effective interest rate = per acre value

Example(s): ($320.30 - $81.07) ÷ 0.0468 = $5,112 per acre x 300 acres = $1,533,516

  • Net share rentals — If there are no comparable properties that were leased on a cash basis in your area, your personal representative may choose to use the net share rentals method. This method uses the same formula as the capitalization method but substitutes net share (in kind) rentals (e.g., crops or livestock) for gross cash rentals. Net share rentals are the excess of the value of the crops the owner received from the lessee over the farm's operating expenses paid by the owner.

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Example(s): Assume the same facts, but Jill's personal representative is unable to find a comparable farm that is leased on a cash basis. There is one, however, that is leased under an arrangement whereby the owner receives payment in kind (e.g., dairy products). The value of the dairy products the owner receives over a five-year period ending on December 31, 2018, is $295 per acre. The farm incurred operating expenses of $62 per acre. Property taxes averaged $19 per acre.

Example(s): The special use value of Jill's farm is $1,371,795 computed as follows:

Example(s): (Average annual net share rental per acre minus Average annual operating expenses minus Average annual state and local real estate taxes) divided by the Average annual effective interest rate equals Per acre value

Example(s): [($295 - $62) - $19] ÷ 0.0468 = $4,573 per acre x 300 acres = $1,371,795

  • Multiple-factor method — If there is no comparable property available or your personal representative does not have the data necessary to use the capital method or net share rentals method, your personal representative can elect to use the multiple-factor method (as used for valuing a closely held business).

Tip: Once special use valuation has been used, the election is irrevocable. However, your personal representative can change the method used to value the farmland at any time, even after the estate tax return has been filed.

What Is The Recapture Rule?

The recapture rule is a law that requires the IRS to impose an additional tax in the event that: (1) your personal representative elects to apply the special use valuation method and (2) the qualified property is disposed of or ceases to be used in the qualifying way within the 10-year period that follows your death (the recapture period).

The IRS may take back, or recapture, the tax savings enjoyed by your estate because of special use valuation if the qualified heir disposes of the property or ceases to use it for the qualified use before the expiration of the recapture period.

What Is a Qualified Use?

Qualified use means that during the entire recapture period, the qualified heir: (1) continuously uses the qualified real property for farming or family-owned business purposes, and (2) the qualified heir or an immediate family member materially participates in its operation.

The qualified heir is given a two-year grace period to commence the qualified use of the qualified real property. The recapture period is extended by the amount of grace period used. A qualified heir is regarded as using the qualified real property for its qualified use only if the qualified heir has an equity interest or a financial stake in the property. The financial stake requirement may be satisfied if the property is leased to a family member on a net cash lease basis or, in the case of a farm, is rented out to someone under a crop share lease.

How Does Property Cease to Be Used for a Qualified Use?

The property may cease to be used for a qualified use if:

  • It is no longer used for farming or closely held business purposes
  • The qualified heir ceases to meet the material participation requirements
  • The principal place of business ceases to be located in the United States
  • The qualified heir loses U.S. citizenship

Tip: If the qualified heir loses U.S. citizenship, the additional taxes may be avoided by transferring the business assets into a qualified domestic trust (QDOT).

What Is Subject to Recapture?

The amount subject to recapture (the additional tax or recapture tax) is the lesser of:

  • The difference between the amount realized upon the sale of the property (or, in the absence of a bona fide sale, the FMV of the property) and the special use value used on your estate tax return, or
  • The difference between what the estate tax would have been had FMV been used and the estate tax incurred based upon special use valuation

The additional tax is a personal liability of each qualified heir to the extent of his or her portion of the taxes imposed on his or her interest.

Example(s): Tony owns a local barbershop, where he and his son Bob work each day. Tony and Bob have run the shop for years and have earned a good reputation. Tony dies, leaving the business to Bob in his will. Tony's personal representative realizes that the business qualifies for the special use valuation method. He speaks with Bob, and after determining that Bob intends to keep the shop, he does a few calculations. The fair market value of the shop on the date of Tony's death is $750,000. The special use value of the shop is $600,000. The special use valuation method reduces Tony's gross estate by $150,000 and saves $38,800 in federal estate tax. So, Tony's personal representative makes the required election and pays federal estate tax of $248,300 using the special use valuation method.

Example(s): Bob continues to run the shop as his father had for the next five years. One day, an agent for a national hair salon chain visits Bob and makes him an offer he can't refuse. Bob sells the shop for $800,000. Because Bob ceased the qualified use of the business before the recapture period had elapsed, the IRS recalculates the estate tax owed by Tony's estate under the recapture rule. The IRS imposes an additional tax of $38,800, because it is the lesser of:

Example(s): The difference between the amount realized upon the sale of the property and the special use value used on Tony's estate tax return:

Example(s): $800,000 (amount realized on the sale of the property) minus $600,000 (special use valuation) equals $200,000

Example(s): The difference between the estate taxes that would have been owed had the special use valuation not been used and the estate tax incurred based on special use valuation:

Example(s): $287,100 (estate tax that would have been owed) minus $248,300 (estate tax paid) equals $38,800

 

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