Source:

Special sample of estate tax returns. See appendix II.

lated into capital gains for long-term holders of land,
while recent purchasers and renters receive a much

smaller benefit, losing at least part of the subsidies
in higher carrying costs or rents. 1/

This "small group of farmers with net income averaging $20,000" produced three quarters of all farm product sales in 1969, although they numbered only 19 percent of all farms. Schultze did not determine to what extent differences in farm income were attributable to differences in subsidies, however.

Liquidity of estates electing

special use valuation

Data collected from our sample of Federal estate tax returns tell us something about the liquidity and debt condition of farm estates. Liquid assets (cash, stocks, and bonds, as well as mortgages owed to and notes held by the decedent) amounted to 13.4 percent of the fair market value of the average taxable estate. The debts of the decedent, including mortgages, operating loans, and personal loans, were 7.9 percent of the taxable estate at fair market value.

Thus, the liquid assets of an average estate in our sample would have been adequate to pay the outstanding debts but not the debts and the Federal estate tax. The data reveal nothing, of course, about the ability or willingness of the inheritors to obtain loans to pay the tax, to use their own funds to pay the tax, or to use Federal estate tax provisions to postpone the date of tax payment and pay the taxes by installment. Loans have been a common method of financing the tax bill, although their availability and cost vary greatly over the business cycle.

Our sample is not representative of all farm estates, since it only includes estates that elected special use valuation, and therefore inferences from the sample cannot be blithely extended to the full population of farm estates. We have no basis for speculating how the liquidity position of other estates differs from that of electing estates.

1/Charles Schultze, The Distribution of Farm Subsidies: Who Gets the Benefits? (Washington D.C.: Brookings Institution, 1971),

p. 3.

CHAPTER 5

MAJOR CONCERNS RELATED TO SPECIAL ESTATE TAX PROVISIONS

AND THEIR EFFECTS ON FARMS

Efforts by the drafters of the 1976 Act to distinguish between "tax" and "real" farmers and to confine estate tax preferences to the latter created an unusual pattern of statutory exclusions and complexities. The special estate tax provisions do not contain carefully delineated distinctions between landowners who hold farmland as investors and the bona fide farmers who operate farms. Therefore the operating farmers must be aware that the restrictions designed to exclude the investors are ambiguous and could cause their estates to be disqualified from electing special use valuation.

BENEFITS OF THE "USE" VALUATION APPROACH

The capitalized net cash rent method of valuing qualified farmland for those electing special use valuation is attractive because (1) the method of valuing the land is explained in the statute and (2) the taxable estate is substantially reduced. One starts with the average annual gross cash rental for actual tracts of comparable local farmland and subtracts the average State and local real estate taxes for the same comparable land. The result is then divided by the average annual effective interest rate charged on new Federal Land Bank loans. The interest or discount rate is considerably important in this procedure because small differences in this rate may give rise to large differences in the dollar value of the decedent's estate. 1/

What is the importance of the discount rate?

The discount rate specified in section 2032A(e) (7), the 5year average of regional Federal Land Bank loan interest rates, is the rate chosen by the Congress to convert future farm earnings into a present value. Present value calculations are commonly performed in financial analyses to find the current worth of an asset that will produce income in the future. The discount rate links the present value to future income by telling how much more valuable present funds are than future funds. A high discount rate means that an investor is much less interested in distant payoffs than short-term returns. Discount rates also reflect expected inflation and the investment's riskiness.

1/ERTA permits substitution of net share rentals for cash rentals in the calculation of "use" valuation for farmland if the executor cannot identify actual tracts of comparable farmland in the same locality that are rented for cash as the decedent's farm property. Chapter 6 discusses problems that could be encountered using net share rentals.

Present values are normally calculated by the formula 1/:

where C1, C2 ·

1, 2,

CN are the earnings or cash flows in years

,N, r is the discount rate, and PV is the present value of the earnings. If the earnings are constant over time and are expected to continue indefinitely, the present value formula becomes

where C is the constant level of earnings or cash flow. This second formula is the one used for special use valuation under section 2032A(e)(7). The earnings, C, are set at the 5-year average of rents for comparable land, less property taxes.

Determining the present value of future farm income is one of the three common ways of valuing a farm; the present value method is not used solely for special use valuation. 2/ A conventional appraisal, however, has recourse to other approaches to determine farm value. The replacement cost method sets the value of the farm at the cost that would be incurred if the land, buildings and other improvements, and equipment had to be replaced today, making some allowance for equipment depreciation. parable sales technique establishes the value of an estate by considering the sale prices of similar properties and then adjusting those prices to reflect any significant differences between the properties and the estate. For example, if a farm estate is similar in every respect to a recently sold farm except in the quality of its irrigation system, the estate's value would be the sale price of the second farm plus or minus the correction for the difference between the irrigation systems.

In conventional appraisal methods, present value calculations are used in conjunction with other estimates. If the present value is much different from other estimates, the appraiser ordinarily looks again at the predicted income and the discount rate to make sure they are reasonable. Thus, while the selection of the discount rate is subjective, the rate alone does not determine the farm's value.

1/Most financial analysis textbooks provide a complete explanation of this formula.

2/Determining the present value of future income is frequently called the "income capitalization" method.

Because electing the capitalization alternative of section 2032A(e) (7) prevents using other methods of valuation, considerable attention has been paid to the discount rate in proposals to change special use valuation. 1/ If the discount rate were reduced, the special use valuation estimates would increase and the tax saving would be lowered. The debate over the appropriate rate is described in the next section. The rent capitalization formula also requires that comparable rents be found. The most significant problem relating to rents is finding a comparable farm that is being rented for cash. The implications of this problem are discussed in the next chapter.

In early 1980 the Treasury Department proposed revising the rent capitalization formula to make it reflect more clearly the value of the farm as farmland. Treasury's position was that the formula caused farm use value to be significantly understated because the interest or discount rate, which is the effective interest rate charged by the Federal Land Bank, was too high for the discounting purpose here. A former Deputy Tax Legislative Counsel for Treasury said farms having no potential use other than farming are being valued at a substantial discount (from 23 percent to 76 percent) under the formula. Also, he said that section 2032A was estimated to cost $14 million per year when enacted; however, current figures show the cost may be as much as $140 million per year. Treasury believed that a more realistic rate would be the greater of either 4 percent or the annual rate of return on equity from farm property rather than the current Federal Land Bank loan rate. 2/ The annual rate of return on equity would be determined on a State-by-State basis from the Department of Agriculture's annual statistical publications, "State Farm Income Statistics" and "The Balance Sheet for The Farming Sector," by subtracting Government payments from net farm income and dividing the difference by proprietors' equities. Their proposal would modify the formula so that the valuation of a farm under the section 2032A formula would approach the farm's fair or current market value. 3/

1/The "five-factor formula," I.R.C. Section 2032A (e) (8), is the only alternative procedure for replacing the capitalization formula for use valuation. Chapter 2 contains a description

of section 2032A(e) (8).

2/The Federal Land Bank loan rate as of June 1981 ranges from 8.21 percent in 1977 to 9.66 percent in 1981 depending on the decendent's date of death and the Federal Land Bank district in which the estate is located.

3/H.L. Gutman, hearings before the Subcommittee on Taxation and Debt Management, pp. 396 and 400. Also see H.L. Gutman, Treasury Department written statement before the subcommittee, pp. 6-10.