Elimination of Stepped-up Basis Poses Hazards to Family FarmsPotential Capital Gains Taxes are Significantly Larger than Cash Rental Rates
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.
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. In fact, it could take years of returns to equal the amount of the tax.
Change in Cropland Values and Estimated Capital Gains Tax
One of the reasons the step up in basis is so important to farmers 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 first year of land value data from USDA) the average cropland value in the U.S. has increased by 223%, 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 high-productivity cropland areas such as Iowa and Illinois, the average cropland value has increased by more than $5,000 per acre since 1997.
Putting Capital Gains Taxes into Perspective
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 is an asset-intensive and low-margin sector. According to USDA-Economic Research Service’s February 2021 Farm Income Forecast, the projected five-year average rate of return on farm assets is 2.8%- significantly lower than the median five-year average return on assets for the S&P 500 of nearly 8.0%. 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.
To minimize the impact of burdensome capital gains taxes, farmers and ranchers use stepped-up basis, which 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 very likely capital gains tax rate of 20%, without stepped-up basis, it’s estimated that 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 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.
Contact: John Newton, Ph.D., Chief Economist with the American Farm Bureau Federation®