The intricacies of special-use valuation.

• Author: Zupanc, Thomas

EXECUTIVE SUMMARY

* The special-use valuation election allows qualifying real property to be valued according to its actual use, rather than its highest or best use, subject to restrictions.

* The decedent or family members must have used the qualifying property for five of the eight years prior to the decedent's death; qualified heirs must use the farm or business property for 10 years after the decedent owner's death.

* The qualified use requirements can be met in a variety of ways, including cash leases to family members, and farm crop-share and hybrid leases.

Heirs to family farms or businesses may be able to reduce estate tax when a large portion of the estate's value includes real property used for farming or business. This article discusses specialize valuation under Sec. 2032A, including qualified property, qualified use, tax consequences and various means for meeting the requirements.

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Sec. 2032A allows an executor to dec to value real property according to it actual use, rather than its highest or best use. This provision, called special-use valuation, can reduce or eliminate estate tax for estates containing qualified property used in family farms and businesses (e.g., campgrounds, parking lots, trailer parks, winter boat storage facilities or off-road driving parks). Of course, every tax advantage has restrictions and disadvantages; Sec. 2032A is no exception. Only certain heirs are eligible for the election; qualification and restrictions on the property's use or disposal apply.

Even though the estate tax is being gradually phased out, the election can still be an important tax saving strategy for estates settled during the transition period. (1) This article looks at the conditions for election of special use valuation, explains special-use value explores some advantages and disadvantages and presents strategies for qualifying for and maintaining such beneficial treatment.

Special-Use Valuation

Although Sec. 2032A permits qualifying real property to be valued according to its actual use, rather than at its highest or best use, the total decrease in the real property's value cannot exceed $850,000. (2) For instance, if the highest and best use of farmland is for development, valued at $2.3 million, but its value as farmland is $1 million, the estate can only be reduced by' $850,000, not the full $1.3 million difference.

To use Sec. 2032A to reduce an estate's value requires the executor to make an election with precise requirements and unforgiving deadlines. In addition, the property, decedent, heirs and size of the estate must meet certain criteria; these conditions are summarized in Exhibit 1 on p. 436.

Alternate Valuation Date

In rare cases, the alternate valuation date may be used in conjunction with the special use valuation election, if it reduces the gross estate's overall value, as well as the estate tax liability. The alternate valuation date is six months from the decedent's date of death (DOD). Any decrease in real property value between the DOD and the alternate valuation date could decrease the estate's total value.

Example 1: The DOD value of farmland at its highest or best use is $2.3 million, the alternate-use value is $1.9 million (e.g., because a major developer or development filed bankruptcy in the interim), and the value as farmland is $1 million. The election to use the alternate valuation date could reduce the property's value to $1.05 million, compared to $1.45 million, using the DOD value minus $850,000. This is because the two valuation tools work in tandem.

Partial Use

Special-use valuation is not an "all or nothing" election. In Est. of Thompson, (3) the Fourth Circuit stated that even if all of the land that would otherwise qualify for Sec. 2032A treatment is not used by a qualified heir for a qualified use, the remaining portion used by a qualified heir for a qualified use could still receive Sec. 2032A treatment. For example, if 98% of a decedent's farm passes to a qualified heir and a 2% interest passes to a nonqualified heir, the special-use valuation election is allowed if the 98% is used for a qualified use. The statute does not expressly require that all concurrent interests pass to qualified heirs.

Consequences of Election

One of the consequences of the special-use election is that it changes the heir's property basis. The lower special-use value becomes the basis, rather than the fair market value (FMV) at the DOD (or elected alternate valuation date).Thus, under Sec. 1040(c), the property's basis will be lower after electing special-use valuation.

Once a special-use election has been made, Sec. 2032A requires qualified heirs or member(s) of their family to materially participate in the farm or business operation for the next 10 years. Generally, material participation means the heirs either operate the farm or business themselves or, in leasing arrangements, bear financial risk and participate in decision making. The material participation issue has been the source of a great deal of debate and litigation with the IRS.

After electing special-use valuation, the heirs cannot dispose of the property (fully or partially) or cease using it in a qualified use for the 10-year period after the decedent's death, without recapturing estate taxes. The recaptured estate tax is based on the number of years...