to a qualified heir when the property receives a stepped-up basis under present law (sec. 1014(b)). Under these rules, property which is purchased from a decedent's estate is not considered to have passed from the decedent to a qualified heir and is not eligible for current use valuation. The legislative history of the 1976 Act stated that property passing in trust is considered to pass to a qualifled heir to the extent that the heir receives a present interest in the trust.5 The Treasury Department has interpreted this requirement to provide that, unless a qualified heir receives a present interest and that interest is specially valued, no other interests in the same property are eligible for current use valuation (Treas. Reg. § 20.2032A-3(b)). In addition, the Treasury regulations define the term "present interest" by reference to the gift tax definition of that term under section 2503 (Treas. Reg. § 20.2032A-3 (b) (1)). That definition is used to determine whether a $3,000 per donee annual exclusion from gift tax is available. Under this definition, trust interests which are subject to the trustee's discretion are not present interests. This is true even if all such interests belong to qualified heirs. Requirement that property must be used for a qualified use Under the fifth requirement, above, current use valuation is available only for real property that is used in a qualified use. A qualified use is a use as a farm for farming purposes or in a trade or business other than the trade or business of farming (secs. 2032A (b) (2), (3) and (4) and 2032A (e) (5). Although the Code requires that the property be used in a trade or business, it does not indicate who must be engaged in that trade or business. The Treasury regulations interpret the trade or business requirement to mean that the decedent-owner (rather than the family member that materially participates in the operation of the trade or business) must be engaged in the trade or business. (Treas. Reg. § 20.2032A-3(b)). This interpretation is supported by statements in the legislative history that current use valuation was not intended to be available for a use that was a "mere passive rental." " General tax principles require that a person have an equity interest in a trade or business for that person to be considered engaged in that trade or business, and the Treasury regulations so require. Subsequent IRS rulings define an equity interest as an arrangement under which the owner's return on the land is contingent on farm production. Under this interpretation, current use valuation would not be available when the decedent leased the farmland on a net cash lease basis. This would be true regardless of whether the cash lease was to immediate family members, distant relatives, or third parties. Material participation requirement Under the sixth requirement above, current use valuation is available for real property only when the decedent or a member of his family materially participated in the operation of a farm or other trade or business in connection with that real property. The term "material "S. Rep. No. 94-1236 (94th Cong., 2d Sess.), p. 610. participation" is defined in section 2032A (e) (6) by reference to the tax on self-employment income (sec. 1402 (a)). Under the self-employment income tax rules, the determination of whether material participation occurs is based on the facts of each case. Material participation does require assumption of a role in the business operation by the participant, even though relatively little activity is necessary to satisfy the test. The adoption by the Code of the material participation test for determining eligibility for current use valuation interacts with the social security laws. Under the social security laws, eligible benefits are reduced when the individual has earned income in excess of a specified amount. The social security laws also use the material participation test to determine whether income is earned (and, thus, reduces benefits) or is passive. Thus, if an individual engages in sufficient activity to meet the material participation test in order to qualify for current use valuation, the income he derives from the trade or business would be considered earned and might reduce the amount of his social security benefits. Determination of current use value Under present law, the current use value of eligible real estate can be determined under either of two methods: (1) the multiple factor method or (2) the formula method. Multiple factor method. The current use value of all qualified real property may be determined under the multiple factor method (sec. 2032A (e) (8)). The multiple factor method takes into account factors normally used in the valuation of real estate (for example, comparable sales) and any other factors that fairly value the property. Formula method. If there is comparable land from which the average annual gross cash rental may be determined, then farm property may also be valued under the formula method (sec. 2032A (e) (7) (A)). Under the formula method, the value of qualified farm property is determined by (1) subtracting the average annual State and local real estate taxes for the comparable land from the average annual gross cash rental for comparable land used for farming, and (2) dividing that amount by the average annual effective interest for all new Federal Land Bank loans." If the formula method is used, the Treasury regulations require that the executor document the actual tracts of cash-rented land upon which he relies. (Treas. Reg. § 20.2032A-4(b) (2) (1)). The Treasury Regulations provide that comparability has the meaning generally ascribed to it under real property valuation rules (Treas. Reg. § 20.2032A-4(d)). Thus, the determination of properties which are comparable is a factual one that must be based on numerous factors, no one of which is determinative. The Treasury regulations then provide that it frequently will be necessary to value farm property in segments where there are different uses or land characteristics included in the specially valued farm. For example, if the formula 'Each average annual computation must be made on the basis of the five most recent calendar years ending before the decedent's death. valuation method is used, rented property on which comparable buildings or improvements are located must be identified for specially valued property on which buildings or other real property improvements are located. In cases involving areas of multiple land characteristics, actual comparable property for each segment must be used, and the rentals and taxes from all such properties combined (using generally accepted real property valuation rules) for use in the formula method given in this section. However, any premium or discount resulting from the presence of multiple uses or other characteristics in one farm is also to be reflected. All factors generally considered in real estate valuation are to be considered in determining comparability under section 2032A. The Treasury regulations provide the following list of factors to be considered in determining comparability— (1) similarity of soil as determined by any objective means, including an official soil survey reflected in a soil productivity index; (2) whether the crops grown are such as would deplete the soil in a similar manner; (3) the types of soil conservation techniques that have been practiced on the two properties; (4) whether the two properties are subject to flooding; (5) the slope of the land; (6) in the case of livestock operations, the carrying capacity of the land; (7) if the land is timbered, whether the timber is comparable to that on the subject property; (8) whether the property as a whole is unified or whether it is segmented, and where segmented, the availability of the means. necessary for movement among the different segments; (9) the number, types, and conditions of all buildings and other fixed improvements located on the properties and their location as it affects efficient management and use of property and value per se; and (10) availability of, and type of, transportation facilities in terms of costs and of proximity of the properties to local markets. The Treasury regulations provide that crop share rentals may not be used under the formula method. Consequently, under the regulations, if no comparable land in the same locality is rented solely for cash, the formula method may not be used and the qualified farm property may be valued only by the multiple factor method. C. Issues Involving Treasury Implementation Several issues have arisen in the Treasury implementation of section 2032A. Among these are the following: (1) Whether the definition of "present interest" contained in the Treasury regulations is a proper interpretation of the law. Whether the Treasury Department's definition of "qualified use" correctly implements the law when applied to cash leases by the decedent to family members.8 (3) Whether the Treasury is justified in interpreting the formula valuation method so as to disallow the use of cash equivalents for crop share rentals. (4) Whether the standards set forth in the Treasury regulations for determining when land is comparable provide adequate guidance or are too burdensome administratively. This issue is addressed in several bills introduced in the Senate during this Congress. See, S. 392 (sponsored by Senator Riegle and Senator Eagleton), S. 395 (sponsored by Senator Wallop and 29 others), and S. 612 (sponsored by Senator Boschwitz and 9 others). Additionally S.J. Res. 204, passed in December 1980, initially would have prohibited the Internal Revenue Service from enforcing its regulation in respect of cash leases to family members. This prohibition was deleted from the final version of the resolution. 'S. 23 (sponsored by Senator Dole and 2 others), S. 392, and S. 395 would allow use of net crop share rentals in the formula. III. DATA ON FARM REAL ESTATE FINANCING Federal Land Banks Federal land banks were the source of an average of 34 percent of the total borrowed farm real estate purchase money between 1977 and 1980. The twelve Federal land banks were established in 1916. Initially capitalized by the Federal Government, this "seed money" was repaid by 1947, and the banks became owned by their borrowers. Loans are made through more than 500 local Federal land bank associations. Both the banks and the associations are chartered by the Federal Government and are subject to the supervision of an independent Federal agency, the Farm Credit Administration. The banks, however, do not lend Government funds nor are their loans guaranteed by the Government. The Federal land banks may make loans ranging from five to forty years. The security is usually a first lien on the real estate or its equivalent. Loans can be made to farmers or ranchers; legal entities such as partnerships, corporations, or other types of organizations legally authorized to engage in the business of farming and ranching; farmrelated business; and non-farmer rural residents. Farmers and ranchers may obtain loans for any agricultural purpose and for other requirements. All loans made by the Federal land banks carry a variable interest rate. Rates charged borrowers are dependent on what the banks must pay investors to purchase their bonds, the chief source of the banks' loan funds. Nearly all of the banks' loan funds come from the sale of securities to investors in the nation's money markets. These securities are backed by the mortgages held by the banks and by their net worth. Selected Farm Real Estate Financial Data Table 2 presents a comparison of average interest rates charged by certain farm real estate lenders for 1977-1980 and the prime nonfarm rate charged by banks. Table 3 lists the primary sources of farm real estate purchase money (percentages) for 1977-1981 (Jan.) (18) |