You are probably aware that all decedent property should be valued at fair market value on the date of death. But were you aware that farms and certain other property can use a special use valuation? This can significantly reduce the estate tax liability.
This special use valuation election can be made under Section 2032A of the Internal Revenue Code (IRC). This election is a lifesaver for many estates.
In this post, we take a look at this special election and offer up some tips. So let’s jump in.
Quick Links
Background
The goal of any estate is to reduce the value of assets that are included in a decedents’ gross estate. This of course includes real estate. But what about a family farm or real estate used in a family business?
Real estate is valued at fair market value, which is based on the highest and best use. But if you have a farm or other certain real estate, you can make an election to have the property valued at a lower rate that is based on the actual, special use value, assuming it meets the following certain conditions:
How do you qualify for the election?
Real property will qualify for election if all of the following conditions are met:
- The decedent was a U.S. citizen or resident at the date of death.
- The farm or real property is located in the U.S.
- At the date of death, the real property was being used by the decedent or a qualified family member for farming purposes or in a business or trade activity. It also could be rented for such use by either the surviving spouse or a qualifying lineal descendant to a family member on a net cash basis.
- The real estate was received from the decedent to a qualified heir.
- The property was owned and utilized in a qualified manner by the decedent or a member of the decedent’s family (as defined) during five of the eight years prior to the date of death.
- The decedent or a qualified member of the decedent’s family materially participated in the activity during five of the eight years prior to the date of death.
- The property must meet the percentage requirements below:
- 50% or more of the adjusted value of the decedent’s estate must consist of the adjusted value of the property that was being used as a farm or in a closely held trade or business and that was received from the decedent to a qualified heir.
- 25% or more of the adjusted value of the gross estate must consist of the adjusted value of the qualified farm or closely-held business real property.
For this requirement, the adjusted value is defined as the value of the property calculated without regard to its special-use value. The value is reduced accordingly for mortgages or any indebtedness on the property, as long as the full value of the decedent’s interest (not reduced by any mortgage debt) is included in the gross estate value.
The adjusted value of the qualified property used in different businesses can be combined together to meet the 50% and 25% thresholds.
What is a Special Use Valuation (the 2032A Election)?
Estate taxes can be reduced substantially by electing for the special use valuation to lower the value of certain real property. The election and a written agreement should be attached to the estate tax return to properly make the election.
The special use valuation election is conceptually very simple. It is used to lower the value of qualified real property used in farming or in a business or trade. The general rule is that this property should be valued at fair value based on its deemed highest and best use. In theory, the best use of the farming land could be to build condos or commercial property.
However, if under certain circumstances, the farm or real estate can qualify for a lower estate tax value based on its actual or “special” use. The goal of the election is to ease any potential estate tax liability and allow for the ongoing use of the existing operations or business.
The qualified farm or real property should be located in the U.S. It must have been utilized by the decedent or a family member who materially participated in the business activities for at least five of the eight years before the date of death, disability, or retirement. At this time, the decedent was required to be a citizen or resident of the U.S.
The adjusted value of the property is required to be 50% or more of the adjusted value of the decedent’s gross estate. In addition, the adjusted value of the farm and real property alone should be at least 25% of the adjusted value of the gross estate.
There are other requirements to consider. The property is required to pass from the decedent to a qualified heir. The I.R.S. defines a qualified heir as a decedent’s family who received the real property from the decedent. Qualified property can also include residential buildings, improvements, and other structures related to the qualified use.
How do you make the election?
The executor is required to make the election. It is made Form 706 (the estate tax return) by selecting the “yes” box on page 2, line 2 and then you must complete Schedule A-1 “Section 2032A Valuation” on subsequent pages.
The election can be made on a late filed return, but it needs to be made offically on the first estate tax return filed by the decendant. Once the election is made, it becomes irrevocable. The total value of any special use property may not be reduced from fair market value by more than $1,180,000 for decedents who passed away in 2020.
But don’t forget the most important part. A properly executed notice of election along with a written agreement signed by each person with an interest in the property is required to be attached to the estate tax return.
The written agreement is usually the most important part. Most recently, the written agreement has resulted in many I.R.S. cases and rulings involving the form and content, actual requirement of attaching the agreement, as well as determining which parties are considered interested parties that must sign the agreement that perfects the actual election.
Any catchs or considerations?
But be careful. Any estate taxes that are saved as a result of the election can be recaptured. If the property is disposed of or if the qualified heir ceases to use the property for the qualified use within 10 years after the decedent’s death, the recapture is applicable.
For example, lets assume a qualified heir sells the property to real estate syndicators within the 10-year period, the recapture provisions would then be triggered. If the qualified heir dies before the 10-year period, the recapture is eliminated.
There is an important purpose of the written agreement. It is to expose all qualified heirs to personal liability for any tax due relating to recaptured estate tax and to initiate a valid federal estate tax lien.
The rules state that the required agreement must be binding on all parties that have an interest in the property. It also is required to designate a representative to act on behalf of the interested parties in all dealings with the IRS.
The agreement is generally referred to as a “recapture” agreement. All parties who have an interest in the property are required to sign the agreement. The definition of “interest” covers a wide variety of interests, including all current, vested, future, and contingent interests. It also will includes any holders of remainder or executory interests and general or special powers of appointment.
Trustees who administer trust assets and other representatives who hold any of the above interests would also be considered a party of interest in the real estate.
The rules allow authorized representatives to act on behalf of certain parties who cannot bind themselves due to incompetency or infancy. The agreement is to be included under Part 3 of Schedule A-I to Form 706, “Agreement to Special Use Valuation Under Section 2032A.“
What is qualified real property?
Qualified real property is generally any farm or real estate that is used in a trade or business. Qualified real property must equal the qualified use and ownership tests.
Qualified use means the property is being used as a farm for farming purposes or in a specific business or trade other than farming. Business or trade applies only to the active involvement in a business. It will not apply to any passive activities or simply the passive rental of property to a person who is not a member of the decedent’s family. Also, no business or trade is applicable if the activities are not engaged in for profit purposes.
The ownership requirement states that the decedent or a family member must have owned and utilized the property in a specific qualified use for five of the last eight years before the date of death. Ownership can even be indirect through a trust, corporation, or partnership.
If the ownership is deemed indirect, then the business must qualify as a closely held business under section 6166. When indirect ownership is combined with periods of direct ownership, the indirect ownership should meet the section 6166 on the date of death and for a period of time that equals at least five of the eight years prior to the date of death.
Any directly owned real property that is leased by the decedent to a separate closely held business is still considered qualified real property if the business entity to which it was rented was deemed a closely held business for the decedent on the date of death and for a sufficient period to qualify under the “5 in 8 years” test previously discussed.
