ERS Modeling Shows Most Farm Estates Would Have No Change in Capital Gains Tax Liability Under Proposed Changes
Researchers from USDA, Economic Research Service used an Estate Tax Simulation Model to evaluate the impact of changes to capital gains taxation at death proposed as part of the American Family Plan (AFP) on family farms.
Results suggest that, assuming farm assets are transferred to a family member who continues to operate the farm, an estimated 1.1 percent of an estimated 32,174 family farm estates would owe a capital gains tax in 2021.
An estimated 18.2 percent of all family farm estates would have a deferred tax liability because of a carry-over basis on farm assets, but the estimated share with this outcome differed by farm size: An estimated 15.5 percent of small family farm estates would have a deferred tax liability, while most midsize, large, and very large farms would have a deferred tax liability.
Changes in U.S. tax policy can have distinct effects on farmers’ after-tax income because of the unique asset and legal structure of farms. To analyze these effects, USDA, Economic Research Service (ERS) uses a customized tax model designed to capture the effect of tax policy on family farms. The American Families Plan (AFP), as originally proposed by the Biden administration, included a number of changes regarding the taxation of capital assets at death, providing ERS researchers an opportunity to demonstrate the potential implications of national policy changes.
To see how a proposal such as the AFP could change family farmers’ tax liability, it is important to understand the current laws around capital gains that result when an asset owner dies, thereby creating a farm estate. Under current law, asset values used to determine gain or loss—known as a tax basis—are increased to current fair market value at the date of the asset owner’s death. Often referred to as a “step-up in basis,” this means heirs do not owe taxes on any appreciation in property value that occurred during the previous owner’s life. (For definitions of tax terms used in this article, see the blue box below.)
For heirs of farm assets, under current law the tax basis for farmland and other assets such as farm machinery, equipment, and livestock is adjusted to the fair market value at the date of death. As a result, the gain in the value of assets that occurred during the deceased owner’s life is not taxed. Furthermore, because the tax basis is reset, an heir who continues to operate the farm will see an increase in tax depreciation deductions and a higher after-tax income. Under the AFP proposal, the step-up of an asset’s basis to fair market value at death would no longer exist for asset gains in excess of $1 million for estates of individuals or $2 million for estates of married couples. Gains on a personal residence of up to $250,000 for estates of individuals or $500,000 for estates of married couples also would be exempt from capital gains taxes. Gains above these exemption amounts would be subject to tax at death. However, the transfer of a family farm to a family member who continues the operation would not result in a tax at death. For farm and business assets exceeding the exemption amounts, the heir would have the same tax basis as the deceased owner, and unrealized gains accrued by the deceased owner would not be taxed at death but would be deferred until the asset is sold as long as the heir was a family member who continued to farm. This tax deferral is known as a carry-over basis. The AFP proposal also would increase the capital gains top tax rate to 39.6 percent for households with income of more than $1 million. Under current law that rate is 20 percent.
Applying the tax changes in the AFP to their model, ERS researchers estimated the share of family farm estates that are expected to owe capital gains tax at death and the taxes owed on nonfarm gains relative to the assets transferred. They also estimated the share of farm estates that would have a deferred capital gains tax liability because their gains exceed the relevant exemption—assuming the farm assets are transferred to an heir who continues to farm—and the estimated amount of unrealized gains that are potentially subject to future capital gains taxes if sold or if the farm is no longer family owned and operated. The estimates represent the effects for 2021 based on current asset values. The share of family farms owing tax at death or the share of estates with potential tax liability due to a carry-over basis on some farm assets could increase in the future if the exemption levels are not adjusted for inflation or if capital gains exceed the rate of inflation.
Three Outcomes for Farm Estates Possible Under Proposed Changes to Capital Gains Taxes
Eliminating the stepped-up basis, along with the proposed exemption levels and carry-over basis on farm gains, would result in three possible outcomes for farm estates. Estates that were estimated to owe no tax at death because they fell under the exemption levels would not be subject to additional taxes. Heirs who continued to farm and have nonfarm gains below the proposed capital gains exemption amount would potentially owe capital gains taxes on these unrealized gains if the farm did not remain family operated and if the nonfarm gains combined with the farm gains exceeded the exemption. Family farm estates with nonfarm gains greater than the exemption proposed in AFP—$1 million for individuals, $2 million for married couples—would owe capital gains tax at death under the proposal.
The method used in the analysis was an extension of the ERS estate tax model. This model uses mortality estimates from the Social Security Administration’s Actuarial Life Tables, which report the probability of a person’s death in the next year given their age. Researchers matched probabilities from the most recently available 2017 Actuarial Life Table to the reported age of principal operators in USDA’s Agricultural Resource Management Survey (ARMS). This allowed researchers to estimate the number of farm estates likely to be created in 2021, capital gains for farm and nonfarm assets, and tax liability for estates owing tax at death.
Using 2019 ARMS data, the study estimated 32,174 family farm estates could result from deaths of principal operators in 2021. Of these estates:
- 80.7 percent would have no change to their capital gains tax liability;
- 18.2 percent would not owe taxes at the time of death but would be subject to a future potential capital gains tax obligation because of a carry-over basis on some farm assets transferred;
- 1.1 percent would owe tax at death and receive a carry-over basis on all farm assets transferred. For these estates, researchers estimated capital gains taxes to be 11 percent of nonfarm assets.
Example of How Tax Change Could Affect Family Farm Estates
Assume a family member inherits 2,400 acres in farmland from a married couple and continues to operate the property as a farm. The property was worth $4 million when originally acquired and has a current market value of $10 million. Because the farm is inherited from a married couple, the relevant exemption is $2 million.
Under current law:
- The original basis of $4 million is “stepped up” to the current fair market value of $10 million (the new basis).
- If the heir sells the land, they pay capital gains taxes on the difference between the sale price and $10 million (the new basis). For example, if the land is sold for $13 million they would pay taxes on $3 million (the difference between the sales price and the stepped-up basis).
Under proposed tax changes:
- The exemption for a married couple would mean that $2 million in gain would be “stepped up” to current fair market value, and the remaining gain would be subject to the original basis of $4 million.
- If the heir sells the inherited farm assets, they pay capital gains taxes on the difference between the sales price and the original basis of $4 million, minus the $2 million exemption. So in the example of a $13 million sale, under the AFP proposal, the heir would pay taxes on $7 million ($13 million sales price minus $4 million basis minus $2 million exemption).
Analysis Focused on Family Farm Estates of Principal Operators in 2021
ERS researchers focused their analysis on the potential changes to capital gains taxation for family farms, which accounted for 98 percent of all U.S. farms in 2019, according to ERS’s America’s Diverse Family Farms 2020 Edition. A farm is defined as any place that produced and sold—or normally would produce and sell—at least $1,000 of agricultural products during a given year. Family farms are defined as any farm in which the majority of the business is owned by the principal operator (the person who is most responsible for making day-to-day decisions for the farm) and by individuals who are related to the principal operator.
The analysis was limited to principal operator households, which accounted for 90 percent of all family farms in 2019. It included family farms of all types of business structure (such as sole proprietorship, partnerships, corporations, and trusts) with farm assets allocated to the principal operator based on that person’s ownership share. The analysis assumes that all estates are transferred to family members who continue to farm.
Because the analysis assumes farm assets are transferred to a family member who continues to operate the farm, only gains on nonfarm assets are taxable at death. The study did not estimate potential taxes owed on farm assets for which a gains tax would be deferred through carry-over basis.
Results show that 95 percent of estates in 2021 would come from small family farms, defined as an operation with a gross cash farm income (GCFI) of up to $350,000. These estates have the lowest average farm and nonfarm asset values. The fewest number of estates would come from very large family farms (GCFI greater than $5 million), which have average total assets of almost $17 million. The table below summarizes the asset values for estates in 2021 according to farm size.
|Small||Midsize||Large||Very large||All estates|
|Number of farm estates||30,567||1,128||430||49||32,174|
|Average value of nonfarm assets (million dollars)||0.82||0.98||1.17||1.73||0.83|
|Average value of farm real estate assets (million dollars)||0.94||3.34||4.81||8.96||1.08|
|Average value of other farm assets (million dollars)||0.12||0.77||1.62||5.82||0.17|
|Average total assets (million dollars)||1.87||5.09||7.59||16.51||2.08|
Notes: Researchers estimated 32,174 estates would be created in 2021 from approximately 1.97 million family farms. Data shown in the figure represents farm estates, not all family farms. Small farms are defined as having a gross cash farm income (GCFI) less than $350,000. Midsize farms have a GCFI between $350,000 and $1 million. Large farms have a GCFI between $1 million and $5 million. Very large farms have a GCFI greater than $5 million.
Source: USDA, Economic Research Service (ERS) modeling based on data from ERS and USDA, National Agricultural Statistics Service, 2019 Agricultural Resource Management Survey; and U.S. Social Security Administration, 2017 Actuarial Life Table.
Effect of Proposed Tax Changes Varies by Farm Size
Using the ERS tax model, researchers found that as family farm size increased, the estimated share of estates that had no change to their capital gains tax liability decreased. Additionally, as farm size increased, so did the potential deferred capital gains tax. The estimated share of estates that had no change to their capital gains tax liability ranged from 83.4 percent of small farms to 3.6 percent of very large farms. For estates with potential deferred capital gains tax on some farm assets and no tax at death, the estimated share increased from 15.5 percent for small farms to 93.9 percent for very large farms. The estimated share of estates that would owe tax at death increased with farm size from 1.1 percent for small farms to 2.5 percent for very large farms.
Size of Estate and Asset Composition Determine Impact of Change
The composition of assets for the three categories of farm estates differed greatly. The total value of assets for farm estates that would owe tax at death ($17 million) was three times the total value of assets for farm estates that only had potential deferred capital gains tax. Additionally, estates that would owe tax at death had a greater amount of wealth in nonfarm assets and less in farm assets compared with farm estates that only had potential deferred capital gains tax. The differences in the amount of farm and nonfarm assets between these two groups led to differences in the share of these assets estimated to be taxable. Estates that would have no tax at death had enough exemption to cover their nonfarm gains, with leftover exemption to apply to farm gains. Estates that would have a tax at death would exhaust their exemptions on their nonfarm gains, with none remaining to apply to farm gains. This means estates that would be taxed at death had a higher proportion of their farm assets that were taxable compared with the group of estates that would have a potential deferred capital gains tax only.
- Estate: An estate consists of the assets an individual owns at the time of death. It is considered a separate entity for tax purposes.
- Capital gain: The amount an asset increases in value, calculated as the difference between an asset’s fair market value and its value when purchased (known as basis).
- Tax basis: The value of an asset when purchased or acquired used to determine gain or loss when the asset is sold.
- Stepped-up basis: Tax basis increased to fair market value when inherited. Eliminates capital gains tax liability on any gains prior to inheriting.
- Carry-over basis: The individual inheriting the asset has the same tax basis as the prior owner. Unrealized gains accrued during the prior owner’s control are not taxed when the prior owner dies but are deferred.
- Exemption: Eliminates tax liability on a specified amount of income or capital gain.
- Depreciation deduction: A method of allocating the cost of an asset over its useful life. For tax purposes, the cost of an asset can generally be written off as a business expense at a much faster rate than the actual decline in the value of that asset.
The Effect on Family Farms of Changing Capital Gains Taxation at Death, by Tia McDonald, Ron Durst, and Christine Whitt, ERS, September 2021
Federal Tax Issues, by Tia McDonald, USDA, Economic Research Service, April 2023
ARMS Farm Financial and Crop Production Practices, by ARMS Team, USDA, Economic Research Service, December 2022
Estimated Effects of the Tax Cuts and Jobs Act on Farms and Farm Households, by James Williamson and Siraj G. Bawa, ERS, June 2018