Is Eliminating the Step-Up in Basis Still on the Table?
We know that last week the House Ways and Means Committee released tax proposals that eliminated the “transfer tax” on appreciated assets either during lifetime or at death. Most people viewed this as a victory for not eliminating the step-up in basis at death.
However, this is just the House bill. We continue to hear chatter, including an article in the Wall Street Journal, indicating the Senate may impose some type of reducing or eliminating the step-up in basis at death, especially if the person owning the assets had borrowed more money during lifetime that exceeded the basis. Even though the transfer tax may be “dead”, the elimination of the step-up in basis is still very much alive.
Even the House proposal had a very key proposal to eliminate step-up in basis for farmers. That was the provision to increase the Section 2032A amount from $750,000 (indexed to inflation – currently about $1.2 million) to $11.7 million (indexed to inflation, likely slightly more than $12 million in 2022).
If the heirs face a taxable estate, they have two options:
- Pay the estate tax and get a step-up in basis, or
- Elect Section 2032A on the farmland and get a reduction in the basis (save 40% now and pay 30% or more when sold).
The Section 2032A value is based upon average comparable rents in the area less applicable real estate taxes. This average rent is then multiplied by a factor based on the state the located in. This factor is the result of dividing 1 by the applicable interest rate from either AgFirst, FCB, AgriBank FCB, Cobank ACB or Texas FCB. The IRS releases these rates every fall and the 2020 rates ranged from a low of 4.53% to a high of 5.37%. Let’s assume the rate is 4.53%. 1 divided by this number is 22.08. If the average rent is $200, then the value per acre is $4,416. The Section 2032A reduction is then the difference between fair market value per acre and this number times total number of acres with a maximum reduction of $12 million.
Let’s see how the Section 2032A works assuming this happens and the estate occurs in 2022 when the lifetime exemption is now about $6 million and Section 2032A maximum deduction is about $12 million.
Robert owns 1,200 acres of land in Washington worth $15,000 per acre. His total net estate is $18 million (we are assuming no other assets or debts). If the heirs do not elect Section 2032A, then about $4.8 million of estate tax will be owed. The average rental income is $300 and the heirs use the CoBank rate of 4.53%. This results in per-acre Section 2032A value of $6,623 or total Section 2032A value of $7,947,600. The reduction is $10,052,400, which is less than $12 million and is allowed in full. If the heirs elect full reduction, they will only owe about $780,000 of estate tax, but their tax basis in the land is only $7,947,600 and it must be farmed by the family for at least 10 years. If in year 11, they finally sell it for $18 million, they will pay capital gains tax on the $10,052,400 Section 2032A reduction which could easily hit 40%. They have deferred the capital gains tax but not eliminated it.
Now lets assume the value of the land is only $10,000 per acre, but everything else is the same. In this case, total estate is $12 million and we can use Section 2032A to reduce the total value of the estate by $4,052,400 (($10,000-$6,623) X 1,200 acres). The heirs will owe about $800,000 of estate tax and then will owe capital gains tax on the $4,052,400 Section 2032A deferral when sold.
The Section 2032A has value for the heirs, but it is not a free lunch. First, the farmland has to be farmed by the family both before death and then for 10 years after death and family does not include nephews, nieces, cousins, etc. It must be lineal decedents. If the heirs mess up during the 10 year window, they are required to pay the estate tax back plus interest and only get to step-up the basis by the amount of tax paid. Plus a tax lien is filed on the affected acres.
As you can see, Section 2032A can help reduce estate taxes, but if the net capital gains tax is greater than the estate tax rate, the heirs will face a large capital gains tax when the land is finally sold.
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
The question of elimination of basis step up is a very real concern and continues despite what’s in the proposals of the House Ways & Means Committee. However, I see tying the question of basis step up to concerns arising from a Section 2032A election as false choice. The entire purpose behind the inclusion of Section 2032A is to provide “special” valuation of certain properties for those beneficiaries who would retain the land and use it for the statutorily designated purposes or uses. If those beneficiaries subsequently determine that they no longer benefit from retention of the land, it’s hard to figure out why a lower basis for determining gain on sale is less than fair. Moreover, consistency of the application of the tax laws over time – for both taxpayers and the IRS – is a bedrock principal of taxation.