Is $13 Million Section 2032A a Good Deal?

President Biden's Green Book Proposal offers farmers a $13 million Section 2032A estate tax exemption. Is this a great deal?

The Green Book proposed increasing the Section 2032A exemption from the current $1.3 million level 10 times to $13 million. It may or may not be indexed to inflation (I could not tell from the proposal).

Section 2032A allows a farmer’s estate to make an election to value farmland at “net rental value” compared to the actual fair market value. The estate will determine average cash rent for comparable ground, reduce it by applicable real estate taxes and then value it based upon the applicable Farm Credit Bank (CoBank, etc.) interest rate.

As an example, let’s assume a farmer has ground in NW Iowa that has a fair market value of $20 million. Comparable rents net of real estate tax is $350 and the Farm Credit interest rate is 6%. The Net Rental Value is $5,833 ($350 divided by 6%). The estate can elect to value the land at $5,833, but the maximum current exemption is $1.3 million.

The heirs are required to farm the land for the next 10 years and if they mess it up anytime during that period, they are required to pay the tax back plus interest. The amount exempted under Section 2032A gets no step-up in basis and if they pay the tax back, they only get a step-up on the tax paid.

Now, if the exemption goes to $13 million, this sounds like a great deal. But is it?

Since there is no step-up in basis on this value and if the heirs sell the land within that 10-year period, the actual capital gains tax owed may substantially exceed the estate tax savings. Let’s review some examples:

Assume a farmer’s estate can eliminate $13 million of value using Section 2032A results in estate tax savings of $5.2 million (at the 40% rate). The heirs keep the ground for at least 10 years. No recapture tax is owed, but they sell the land in year 11. Let’s assume the other Green Book proposals are in place and the farmer lives in California. This results in a tax rate of 39.6% (federal rate) plus 5% (Net Investment Income Tax rate) plus 13.3% (top California tax rate) or 57.9% times $13 million equals $7,527,000. This means the heirs owe an extra $2.327 million of tax from using Section 2032A. They did get the benefit of not paying estate tax for 11 years but is that worth $2.327 million. If their interest rate is about 5%, then the interest savings is about $260,000 per year times 11 years is about $2.8 million. Yes, they are about $500,000 ahead, but not a great deal.

Now, let’s assume they sell in year 5. They now have to pay back the estate tax savings of $5.2 million plus let’s assume $800,000 of interest. They now get a step-up of $5.2 million, so their net gain is now $7.8 million times 57.9% equals $4,516,200 of tax or total tax owed of $$9.7 million of tax versus paying the original $5.2 million of tax or an extra cost of $4.5 million. There is no interest savings since they had to pay that back to the IRS.

As you can see, if the maximum capital gains rate exceeds the federal estate tax rate and heirs sell land within the first 15 years of ownership, the value of using Section 2032A is minimal. However, if they sell the land within 10 years of inheriting the land, the cost will be substantial assuming all of the Green Book proposals are in effect.

We will keep you posted.