What qualifies for farm and business special use valuation

The property and estate must qualify together

The decedent must have been a United States citizen or resident at death. The executor must elect special use valuation and file the required agreement designating the property.

The real property must be in the United States, pass from the decedent to a qualified heir, and be in qualified use by the decedent or a family member at death.

Qualified use means an active farm or other trade or business. Merely renting property passively to someone outside the decedent's family does not qualify.

Two estate composition tests apply, using adjusted values:

• At least 50% of the adjusted gross estate must consist of real or personal property used for a qualified use by the decedent or family at death and passing to qualified heirs.
• At least 25% must consist of real property passing to qualified heirs and meeting the ownership, use and participation test below.

Adjusted values use estate tax values determined without special use valuation, reduced by the deductions allowed under the statutory adjusted value rules. The reductions apply to the gross estate and, as applicable, the particular property.

The ownership, use and participation test generally requires periods totaling at least five years within the eight years ending at death. During those periods, the decedent or family must own the property and use it for a qualified use.

The decedent or a family member must also materially participate in operating the farm or business during those periods.

Property can pass from the decedent under the statutory inherited property rules, through acquisition from the estate, or through acquisition from a trust. The trust route applies only to property included in the decedent's gross estate.

These acquisition routes do not replace the other eligibility requirements.

Eligible farm property can include buildings and improvements

Property meeting the ownership, use and participation requirements can include roads, buildings, structures and improvements functionally related to the qualified use.

Residential buildings and related improvements can qualify when regularly occupied by the owner, lessee or their employees operating or maintaining the property.

Farms can include ranches, nurseries, orchards and woodlands. Farming includes animal husbandry and tree production, including preparing trees for market but excluding milling.

Handling, drying, packing, grading or storing unmanufactured agricultural commodities on a farm counts only if the owner, tenant or operator regularly produces more than half the commodity treated.

Participation depends on personal work and management

Actual employment of the decedent or a family member for at least 35 hours weekly constitutes material participation. Lesser work also qualifies when personally necessary to manage the entire operation.

Seasonal inactivity does not prevent participation when all necessary functions are performed. The arrangement requirements below also apply where relevant.

Without that direct involvement, the regulation's activity standards and applicable self employment regulations govern. For a participant who is self employed in the operation, business income must be earned income for self employment tax purposes.

No single factor controls. Physical work and management decisions are principal factors, and the participant must regularly advise or consult with the other managing party and participate in a substantial number of management decisions.

Paying self employment tax does not conclusively establish participation. If none was paid, nonparticipation is presumed unless the executor demonstrates participation to the IRS and explains the nonpayment.

Any taxes, interest and penalties determined to be due must also be paid.

Each participant's activities are assessed separately. At least one person's activities must be material at a given time, and simultaneous participation does not multiply the elapsed qualifying years.

IRS instructions allow gaps of 30 days or less to be disregarded only when each gap is both preceded and followed by uninterrupted participation exceeding 120 days.

Indirect ownership requires additional evidence

Indirect ownership also requires the decedent's business interest to meet the statutory closely held business test at death. That test must hold for enough additional time, combined with direct ownership, to total five of the preceding eight years.

Even full time involvement with indirectly owned real property requires an arrangement between the entity and the decedent or family member specifying the services to be performed.

Lesser involvement requires an arrangement for actual production or production management when a nonfamily member, trust or business entity uses the land. The arrangement may be oral or written, but must be formalized and provable.

Activities outside the arrangement do not count. Neither do activities of agents or employees other than family members, and family relationships must exist when the activities occur.

A title, salary or partnership profit share alone does not establish participation. Retaining a professional manager does not itself prevent qualification, but the decedent or family member must personally materially participate under the arrangement.

Retirement, disability and surviving spouses have specific rules

If the decedent's participation fails the ordinary test, continuous receipt of Social Security retirement benefits or continuous disability through death may permit a substitute participation period.

The substitute uses the eight years ending when the longer qualifying continuous period began, requiring at least five years of participation. Disability means a mental or physical impairment preventing material participation in the operation.

For a surviving spouse receiving qualifying property from a prior spouse, active management may substitute for material participation. Qualification of the prior spouse's property does not require an actual special use election or agreement designation.

Separately, a surviving spouse or lineal descendant does not fail qualified use solely by renting the property to that person's family member on a net cash basis. This rule does not eliminate the separate participation requirement.

Successive interests need a separate heir review

If property has successive interests, qualified heirs must receive all those interests, and the election must include all their interests.

A remainder cannot depend on surviving a nonfamily member or be subject to divestment in favor of one.

Farm valuation needs actual comparable rental evidence

When the farm cash rental formula is used for elected property, subtract average annual state and local real estate taxes on actual comparable tracts from average annual gross cash rent for those tracts.

Divide that result by the average annual effective interest rate on new Federal Land Bank loans. Each annual average uses the five most recent calendar years ending before death.

The method requires actual comparable property rented solely for cash to be identified for each of the five calendar years preceding the death year. Different tracts may support different years.

County rental averages and appraised rental values cannot substitute for actual comparable rentals.

Comparable property must be in the same locality under generally accepted valuation rules. Mileage and political boundaries alone do not decide locality, and no single factor determines comparability.

Different uses or land characteristics frequently require separate segments. Property with buildings or improvements requires comparables with comparable buildings or improvements.

Comparable rentals must arise from transactions at arm's length, with cash rent independent of production. The lease must neither contemplate nor involve material participation by the lessor or a lessor's family member other than the lessee.

Government leases charging less than a private owner leasing for profit would demand are unacceptable. Family leases are unacceptable when their returns are not commensurate with local leases between unrelated parties.

These restrictions concern comparable rental evidence. They do not create a blanket prohibition on inherited property leased within a family.

When comparable gross cash rentals are unavailable, comparable average annual net share rentals may substitute if comparable land supports that determination.

Net share rent equals produce value received by the lessor minus cash growing expenses the lease requires the lessor to pay. The other formula inputs remain unchanged.

If neither rental method is available, or the executor elects the alternative, the closely held business valuation method applies.

That alternative considers operating income capitalization, fair rental capitalization, qualifying state use assessments, qualifying comparable sales and other factors fairly measuring farm or closely held business value.

Expected income considers a reasonable period, prudent management, traditional local cropping patterns, soil capacity, terrain and similar factors. State assessments must come from a differential or use value assessment law and are only one factor.

Comparable sales must be in the same geographical area, sufficiently removed from metropolitan or resort influences that nonagricultural use is not a significant price factor.

Two related terms

Starting the estate planning conversation

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Common questions