This week, Gail describes ways to save the family farm from death and taxes.
Dear Gail —
I know you don’t usually answer these kinds of questions, but I’m hoping you make an exception.
I’m an only child of a family that — until I came along — has always been in farming. Although I don’t live there now, I grew up on the farm my mom inherited from her parents.
When I was growing up, we were so far away from things — shopping, the nearest city, the airport — it almost felt as if we lived in another country! But as has happened in a lot of places, suburbia has now almost reached our farm. You wouldn’t believe what they are charging for the 5-acre “estates” they’re building just a few miles down the road.
As a result, the land has soared in value. It was worth $800,000 when my mom inherited it and is now appraised at around $3 million ($600,000 of that is the house). And it keeps going up.
Because she didn’t feel she could run it by herself, my 80-year old mother no longer lives on the farm. She leases the land out to others.
Here’s the thing: my mom doesn’t need any more income. My dad had a big insurance policy. The farm is going to present a huge estate tax issue when she dies which, hopefully, won’t be for at least another ten years based on how long everyone in her family lives.
The farm and the house I grew up in have a lot of sentimental value to me. I spend every summer there with my own three children. I don’t want to end up selling the property just to pay the estate tax. Frankly, I’d like to see as little as possible paid.
And, although they “took the girl out of the country, they didn’t take the country out of the girl.” I haven’t talked to my mom about this yet, but I’d like to see some or most of the land remain undeveloped, maybe turned into a sanctuary for wildlife or a park.
We’ve talked to several attorneys and they’ve proposed things like “family limited partnerships” and “self-canceling installment notes.” But, frankly, I’m completely overwhelmed. And if I don’t feel comfortable with something, I’m never going to be able to convince my mom to make a move.
Any advice would be appreciated.
Dear Gloria —
I know exactly what you’re talking about. Most everyone has their own stories about how the seemingly incessant march of urbanization has changed the landscape — and not always for the better.
It seems to me that people ostensibly move out and away from cities in order to enjoy the things the “country” offers — less traffic, a chance to get closer to nature, quiet, more open space, a slower pace of life. And then they get annoyed that they don’t have all of the “conveniences” they had when they lived in a more developed area.
To meet this demand, the next thing you know, the same stores, restaurants, theaters, and businesses start cropping up in “the country” and quickly turn it into the very place people were trying to get away from!
In other words, “development” doesn’t always mean “improvement.”
You don’t often hear the word “improvement” uttered in the same breath as “estate tax,” but that changed when Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”). This massive piece of legislation completely altered the estate tax system that had been in place for decades. However, the changes are being introduced in stages.
As you may know, the top estate tax rate has been declining. From 55 percent in 2001, it is now at 47 percent and will decline to 45 percent in 2007. In 2010, the estate tax is completely eliminated — but just for one year! That’s because EGTRRA has a built-in “sunset” provision that says everything in it expires (fades into the sunset) at the end of 2010. So unless Congress acts, estate tax rates will jump back up to their 2001 levels at that point.
In addition to the gradual decline in the estate tax rate, a number of other things are also changing. The amount of assets you can leave someone who is not your spouse is increasing. In 2001 it was $675,000. This year is $1.5 million. Next year it increases to $2 million. By 2009 you’ll be able to leave non-spouse beneficiaries as much as $3.5 million without owing any estate tax. Of course, when the estate tax goes on hiatus in 2010, there is [no limit] on the amount of assets you can leave non-spouse beneficiaries.
Estate tax isn’t the only tax you might pay when you die. If you leave assets to individuals who are two generations younger than you are, known as “skip” persons (because their birth skipped a generation), you might also owe generation-skipping transfer tax, or GSTT. Grandkids are ”skip” persons, for instance.
Let me back up. The estate tax is a “transfer” tax, i.e. a tax you pay for the privilege of transferring property at your death to another person. If that individual then transfers it when [they] die to someone else, their estate pays the estate tax again. (Assuming that the total property exceeds the limit allowed to pass tax-free, i.e. $1.5 million this year.)
Congress implemented the GSTT because people figured out if they transferred assets directly to their grandchildren instead of their children, the property would “skip” a generation and would only be subject to estate tax once (grandpa to grandkid) instead of twice (grandpa to child, then child to grandkid). No dice. If you leave property directly to your grandchildren, you could end up paying both estate tax and generation-skipping transfer tax.
Under EGTRRA, this year the generation-skipping transfer tax rate is the same as the top estate tax rate (47 percent) and the total amount you can leave individuals in a “skip” generation without owing any GST tax is the same as the total amount you can leave to non-spouse beneficiaries without owing any estate tax: $1.5 million.
In other words, someone could leave their grandchildren (or any “skip” persons) up to $1.5 million worth of assets and not owe any estate tax or generation-skipping tax.
However, if they left anything else to someone other than their spouse, there would be estate tax to pay. And if that person were at least two generations younger, there would also be GSTT.
Last but not least, giving things away at your death isn’t the only time a transfer tax is levied. If you give too much to someone while you’re alive, you’ll also pay a tax. Under these circumstances it’s called a “gift” tax.
Currently, you’re allowed to give/gift as much as $11,000/year to as many people as you want. There’s no limit on how much you can give your spouse. But if you give someone other than your spouse more than $11,000 in a calendar year, you have to file a gift tax return.
You won’t immediately owe tax on any excess gift. Instead, you’ve got to keep tabs on all the excess gifts you make over your lifetime and account for them- and any tax you might owe on them- when you die. (OK, OK. Your executor has to do this.)
The total amount of excess annual gifts you can make before triggering gift tax is $1 million. Without going into the details, this is tied into the estate tax, but not the way it used to be, thanks to EGTRRA.
Sorry for the lecture! I just wanted to lay some groundwork.
Estate planning attorney Julius Giarmarco with the Detroit firm of Cox, Hodgman, & Giarmarco, explains that a “self-canceling installment note,” or “SCIN” is one strategy that can help reduce estate taxes when someone owns an asset that is appreciating in value and wants to transfer it to other family members to reduce estate taxes.
In general, here’s how it would work: Mom sells you the farm for $3 million, in exchange for a note that you are obligated to make payments on. However, if Mom dies before the note is paid off, it’s cancelled and the property passes to you free and clear.
Typically, a SCIN is set up to pay interest only, with a balloon payment of principal at maturity. So you’d have to come up with the interest payments each year (or monthly) on the note. If the asset is income-producing, such as leased land, this might be enough to cover your payments.
When the note’s term is up, hopefully the property is worth more than what you paid Mom for it. Let’s say it’s now valued at $5 million. You are the owner. You sell $3 million of land worth to re-pay Mom her principal. The remaining $2 million gain — that Mom would have paid estate taxes on at death — has been removed from her estate and transferred to you without any tax consequences.
As you might expect, this type of transaction has to meet very stringent IRS requirements in order for it to not run afoul of the tax laws. For instance, Mom can’t agree to sell you the farm for $100; the property must be independently appraised.
The term of the note can’t be longer than the seller is expected to live. In other words, you can’t have a 30-year note for an 80-year old woman.
And you have to use an interest rate set by the IRS.
There’s also a cost, or “risk premium,” for the privilege of having the debt cancelled if the seller dies before it’s paid off. According to Giarmarco, there’s nothing in the tax code or regulations that spells this out, but in practice, this means either increasing the selling price or raising the government-established interest rate.
Say, based on your mom’s life expectancy, the SCIN has a term of 9 years. By Giarmarco’s calculations, based on the value of the farm, you would either have to use an interest rate of 13.8 percent (instead of the “applicable federal rate” of 3.8 percent) or you’d have to increase the size of the note to $6.2 million (instead of $3 million)!
If Mom dies before the note is paid off, the government’s position is that the appreciation on the property ($5 million-$800,000= $4.2 million) would be taxable — but as a capital gain, i.e. taxed at 15 percent (through 2008).
If she hadn’t sold it via the SCIN, she’d still own the farmland at her death and the appreciated value of the property — $5 million — would be included in her taxable estate and potentially subject to a 47 percent estate tax.
In other words, under the SCIN scenario she’d pay $630,000 in capital gains tax instead of possibly $2.35 million in estate tax! The SCIN has essentially “frozen” the value of the property and converted it into a capital gains asset.
Giarmarco says there’s a good argument that there is no cap gains tax at death. He’s waiting for more direction to come from the courts which could prove the IRS wrong on this point. If he’s right, this would truly SCIN the tax off the government. (Ahem.)
“A SCIN is most appropriate when the seller isn’t expected to live to her life expectancy,” says Giarmarco, whose firm can be found at http://www.disinherit-irs.com. “Even if the government is correct about its position concerning capital gains tax, the estate tax savings justifies using this strategy” under these circumstances.
It sounds as if your mom’s extremely healthy, Gloria, so a SCIN is probably not the route to take.
Next week when Pittsburgh attorney Brad Franc discusses another possible solution!
Bracing for a barrage from the barristers bench,
Note: Some attorneys couple a SCIN with something called an “Intentionally Defective Grantor Trust” which can further reduce the size of the property seller’s estate.
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