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 biggest capital-gains-tax rate is 20 percent. 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.
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. The magnitude of the burden depends on the change in the asset value, but it would likely significantly exceed the annual income generated by the assets. It could take years of returns to equal the amount of the tax. Using the U.S. Department of Agriculture’s 2020 Land Values Summary, the change in cropland values from 1997 and cash-rental-rate data – and assuming a capital-gains-tax rate of 20 percent – this article estimates the capital-gains tax as a share of cash-rental rates on cropland, and the number of years needed to pay the capital-gains tax based on cash-rental rates if the tax is fully capitalized into the value of land and the step up in basis is not preserved.
Cropland values change, affect tax
One of the reasons the step up in basis is so important to farmers and ranchers is that 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 significant capital-gains taxes. For example since 1997 – the first year of land-value data from the USDA – the average cropland value in the United States has increased by 223 percent, rocketing from $1,270 per acre to $4,100 per acre. In portions of the Corn Belt the change in land values is even more significant. In South Dakota, North Dakota, Wisconsin, Minnesota, Nebraska and Iowa the change in cropland values since 1997 exceeds 300 percent.
In excellent-productivity cropland areas such as Iowa and Illinois, the average cropland value has increased by 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 percent 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 in the United States, the average capital-gains tax would exceed $560 per acre.
Capital-gains taxes put into perspective
A capital-gains tax of more than $500 per acre doesn’t immediately convey the significance or magnitude of the tax increase, so it’s important to put the tax into perspective. Farming and ranching is an asset-intensive and small-margin sector. According to the USDA-Economic Research Service’s February 2021 Farm Income Forecast, the projected five-year average rate of return on farm assets is 2.8 percent. That’s significantly less than the median five-year average return on assets for the S&P 500 of almost 8 percent. At that rate $1 million in farm assets would only generate an annual income of $27,800. As a result of reduced returns on farmland assets, taxes based on asset valuation become even more significant for agricultural producers because the assets generate much smaller 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 United States would equate to more than 400 percent of the average cash-rental rate. Across the United States the capital-gains tax as a proportion of the cash-rental rate ranges from 74 percent in New Mexico to more than 1,300 percent in New Jersey. Let that sink in. The capital-gains tax per acre in 37 states is more than 400 percent of the average cash-rental rate. That’s a very large tax obligation for many farm families to meet no matter the size of the farm operations. That 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 increasing much faster than cash-rental rates, because non-agricultural uses increase land prices. In the center of the country the range extends from about three years to six years to pay the tax.
To minimize the impact of burdensome capital-gains taxes, farmers and ranchers use stepped-up basis. That provides a reset for the asset-value basis during intergenerational transfers. 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. Assuming a likely capital-gains-tax rate of 20 percent, without stepped-up basis it’s estimated the tax burden on farmers and ranchers inheriting cropland would be significantly larger than the cash-rental income generated on the farmland. In the case of most farm operations, the capital-gains tax would take several years of rental income to pay the tax obligation.
Heirs facing those 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 those 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 those family operations long into the future.
John Newton is the chief economist with American Farm Bureau Federation Market Intel; visit www.fb.org/market-intel for more information.