Taxes! This is usually the first question that comes up for families who are considering gifting their farm to the next generation. A fact that sometimes surprises clients is that Oregon and Washington have no gift tax. Because of this, the taxes that are a concern when gifting during life are the federal gift tax and, in the event the children ever sold the farm, the capital gains tax.
Let’s look at each tax through the lens of a family farm. Currently, most individuals can give a large portion or all of their farm assets to their children with no gift tax. The federal gift tax exemption is currently set at $11.7 million per person. Because of this, a married couple can give a farm valued at $23.4 million to a child and there is no gift tax payable by either the parents or the child. Many people do not realize there is this lifetime gifting exemption on top of the $15,000 per year that is allowed as an annual exclusion gift.
On the capital gains side, the children who receive the farm interests also receive the parents’ income tax basis in the farm. If the children ever sold the farm, then they would pay capital gains tax on the difference between the sale price and the income tax basis their parents had. If the farm is inherited at death, there may be estate taxes paid, but the farm would receive a new income tax basis to fair market value as of the date of death.
Most parents who gift to children do not care about this income tax basis risk for a couple reasons.
First, they don’t want their children to sell the farm. The goal is to create a legacy by keeping the farm in the family. If a child does sell the farm against their parents’ wishes, then the child will deal with the tax consequences at that time.
A second reason involves the recent proposals for estate tax and capital gains tax. The maximum allowed to pass tax free by gifting and inheritance is scheduled to decrease within the next few years. The current rule allows a “step up” in income tax basis to fair market value for assets in a person’s estate at death.
A few weeks ago, the Biden administration proposed new rules for capital gains taxes that would trigger capital gains tax at death on gain over $1 million. On top of that, there is also a proposal to raise the top tax rates for capital gains.
There is not much known yet about whether a change like this will pass through the legislature or if there would be an exception for family farms. If not, then the administration may go back to proposing a reduction in the estate and gift tax exemptions. What we do know is that future tax law is unknown. This requires people to decide for themselves whether they think taxes will be going up or down in the future.
We also know that the current estate and gift tax exemption is one of the most favorable exemptions we have ever had, so many people are timing their gifts while the exemption is favorable.
Once you have decided to make a gift, the next question is whom you want to gift to. Frequently, this involves a decision between creating a trust to benefit your spouse, or gifting in trust or outright to your children. A trust is an agreement between the person creating it (the donor) and the person in charge of it (the trustee) to hold assets (like a farm) for the benefit of someone (the beneficiary).
Some spouses decide to gift to an irrevocable trust called a Spousal Limited Access Trust (“SLAT”). This trust has many requirements, but essentially, a spouse can gift an asset like a piece of real estate or business interest to an irrevocable trust for the benefit of the other spouse for life. If the trust is set up correctly, this will keep the assets out of both spouses’ estates at death and allow the trust to pass estate-tax free on to the children after both spouses pass away.
Many clients decide that they are ready to pass the farm directly to the next generation. If this is the goal, then what is the best way to do so? One option is an outright gift. A gift can also be to a trust that has some controls on the way the property can be used.
Finally, how much to gift? People often decide on a partial interest gift rather than giving a whole piece of real estate or an entire business. This could be a minority interest in the real estate or business so that the parent can continue holding the majority interest. Prior to giving, parents must ensure that they are retaining sufficient funds to continue their own lifestyles. Gifts to children should only be assets that a parent does not need.
Gifting the farm is not just about the numbers but also about the people involved. It requires evaluating personal goals and values to decide whether the time is now.
Maria C. Schmidlkofer is an estate planning, tax, and farm succession attorney in Schwabe’s Natural Resources industry group. She can be contacted at either firstname.lastname@example.org or 503-540-4265. This article is a brief summary of the tax implications of gifting a family farm and does not constitute legal advice. For legal advice specific to your situation, you should contact an attorney.