Farm Horizons, Oct. 2016
Should I sell my land or keep it for rental property?
By Myron Oftedahl
I get the question fairly often about what land rents should be, and I hear often enough concern that a particular farm will be transferred to the kids after mom and dad die. The concern is what the kids will decide to do with the property; will they sell it, or will they continue to rent it?
This becomes more of an issue when you consider that about two-thirds of the farmland in the US is rental property. This also gets compounded when the kids no longer live in the area, and the ties to the farm become weaker. So, what is the right answer?
First, let’s look at the difference between gifting and inheritance of the property.
If the farm was gifted, then the cost basis of that property remains what the cost basis of the previous owner was. In other words, if Mom and Dad owned a piece of property with a cost basis of $300 an acre and they gifted the property to one of their kids, the cost basis remains at $300 an acre.
If the kid decides to sell it for $5,000 an acre, then he/she is going to pay capital gain taxes on $4,700 per acre. Capital gains tax rates can be up to 40 percent. If we assume the 40 percent rate, the child will have $2,844 an acre after taxes.
You could say that I over simplified this, but we have to start somewhere.
So, for the rest of this discussion, let’s assume that this property is transferred through the estate and received the stepped-up basis value. Now we have a piece of property with a cost basis of $5,000 an acre and $40 an acre Real Estate tax cost.
A fair return on this investment is usually in the 3 to 5 percent return. At this point, let’s use a 4 percent return, so the investment value would be $200 an acre plus the Real Estate taxes of $40, giving you a rental rate of $240 an acre. Using the $200 an acre for an investment return, it would take 14.2 years to earn the same $2,844 that would have been received if the land was sold.
If there were two children in this scenario, child one received 80 acres as a gift, and child two received 80 acres as an inheritance, who comes out better?
If both are farming the land, it doesn’t matter. If both decide to sell, it makes a huge difference. One will pay capital gains, because of the low cost basis. One will not pay capital gains because of the stepped-up basis, because it was transferred through the estate.
Should you sell inherited land or not?
It will come down to a personal decision, and will probably be heavily influenced by your financial position at the time. You have just received an income stream for the rest of your life, and possibly your children’s lives.
If we use the same 80 acres from above, that is $16,000 after the Real Estate taxes have been paid. That is like having a part-time job without having to put in any hours at work. If we assume that you will live for another 40 years, that is $640,000 of income, compared to $400,000 if it was sold.
By renting the property, you just received income for an extra 15 years (400,000 divided by 16,000 equals 25 years). Which would you rather have? Cash now, or income for the rest of your life; and still have 80 acres of land to pass on to your children for them to have an income stream?
If you are willing to develop a relationship with your renter, and value the extra things that the renter will do with this piece of property, like mowing the ditches, repairing the tile lines, maintaining or improving fertility and soil tilth, managing the property for FSA programs, and being good stewards for soil conservation, you can be reasonably assured of a lifetime income stream.
If you are not interested in a relationship with your renter and choose to receive the highest rental bid each year, then I will assure you that those things will not be done.
Fertility will probably be bare bones, in order for the renter to reduce expenses to make any return on that farm.
I have seen a couple of farms that have switched renters, and now have a huge gully through the farm because no soil conservation was practiced. This will be a large expense for the owner, or some future renter to correct.
I would urge all landowners to have this discussion with your renter how will they take care of your property? Will they maintain fertility? Will they use soil conservation practices? Will they try to improve the property? Will they maintain weed control, both in the field and in the ditches, building site, and any non-tillable areas? Will they give a report once or twice a year?
I would urge all renters to have this discussion with your landlords. What do you bring to the table when it comes to managing their land? What will happen to the land when the current owner dies? Do you, as the renter, know the children? Have you ever met them? Managing rental land is very much based on personal relationships. In some ways, the landlord is like an employee to your business. How do you treat your employees? How do you treat your landlords?
To summarize this whole article, I would start with the personal relationships. How well do you know your landlord’s family? The landowner’s family should have a discussion about what happens to the land. Will the kids keep it, or will they sell the land? What are the consequences?
Agriculture is a capital intensive business and very few farmers can afford to borrow enough money to own every acre that they farm, so we need the rental land. Every farm needs enough land to operate efficiently with the machinery that they have.
If all of the rental land went on the market, I would guess that the majority of the land would be owned by large investment firms because the current active farmers could not access enough capital to purchase all of it.
I would also guess that if this were to happen, the land values would fall dramatically because of supply and demand. There would be a lot of land for sale, and eventually we would run out of buyers with enough access to money.
Sell or rent your land? Ultimately the decision is yours, but I hope that I have given you some things to consider.
Three times a day, you need a farmer.