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Commentary: Stepped-up basis in tax policy protects family farms

Issue Date: April 21, 2021
By John Newton and Scott Gerlt
The rising value of U.S. farmland would lead to significant capital gains taxes on inherited farmland without use of a stepped-up basis to minimize the impact on family farms.

Any change in capital gains tax policy that eliminates or scales back stepped-up basis could result in a massive tax burden on the agricultural sector.

Capital gains taxes are based on the change in the value of an asset, such as farmland, livestock or timber, when that asset is sold. Currently, the top capital gains tax rate is 20%. To reduce the capital gains tax, farmers and ranchers use stepped-up basis, which provides a reset for the basis during intergenerational transfers.

In effect, upon the transfer of assets following a death, the basis is reset to the market value at the date of death. Following the adjustment, taxes can be levied only on gains realized by the individual during his or her ownership, not on gains realized prior to the step up in basis.

One of the reasons the step up in basis is so important to farmers and ranchers is the asset values in agriculture have appreciated significantly in recent years. As a result, when farmland is inherited, without a step up in basis, many farmers would face very significant capital gains taxes. For example, since 1997, the average cropland value in the U.S. has increased 223%, rocketing from $1,270 per acre to $4,100 per acre.

In areas such as Iowa and Illinois, the average cropland value has increased more than $5,000 per acre since 1997. Similar changes in cropland values have occurred in areas near metropolitan centers, such as in Florida and California and along the East Coast. Assuming a capital gains tax of 20% on the change in cropland value from 1997 to 2020, farmers would face estimated capital gains taxes of more than $1,000 per acre in California, Iowa, Illinois, Delaware and New Jersey. Based on national average cropland values, the average capital gains tax would exceed $560 per acre.

A capital gains tax of more than $500 per acre does not immediately convey the significance or magnitude of the tax increase, so it's important to put this tax into perspective. Farming and ranching is an asset-intensive and low-margin sector.

According to the U.S. Department of Agriculture, the projected five-year average rate of return on farm assets is 2.8%. At this rate, $1 million in farm assets would only generate an annual income of $27,800. As a result of lower returns on farmland assets, taxes based on asset valuation become even more significant for agricultural producers, because the assets generate much lower returns than other asset classes.

The capital gains tax was calculated based on the appreciation of farmland. Based on the average change in cropland values, U.S. average cash rents and the estimated capital gains tax, the capital gains tax in the U.S. would equate to more than 400% of the average cash rental rate. Let that sink in. The capital gains tax per acre in 37 states is more than 400% of the average cash rental rate—a very large tax obligation for many farm families to meet, no matter the size of the farm operation. This obligation discourages the sale of land, thereby potentially increasing the cost of farmland.

Another way to put the potential effect of removing stepped-up basis into perspective is to compare the potential capital gains tax on land to the rental income from the land, in order to estimate how long it would take to offset the loss of stepped-up basis if the capital gains tax was fully incorporated into the land price.

The number of years varies by state, but is more than four years based on national average rental rates and the estimated tax burden. In states with larger urban areas, it would take longer to pay off the capital gains tax, because land values are rising much faster than cash rental rates, as non-agricultural uses drive up land prices.

Heirs facing these taxes would incur steep costs from selling the land, thereby increasing costs for everyone in the marketplace. If an estate is passed on with debt, it may not be possible for the family to meet the tax obligation.

To protect these family farms and minimize the impact of capital gains taxes, it's important that farms have continued access to stepped-up basis. Eliminating stepped-up basis to generate more federal income risks the livelihood of America's family farms and the economic sustainability of these family operations long into the future.

(John Newton is chief economist for the American Farm Bureau Federation and Scott Gerlt is an economist with the American Soybean Association. This piece is adapted from a post on the AFBF Market Intel blog.)

Permission for use is granted, however, credit must be made to the California Farm Bureau Federation when reprinting this item.

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