Passing the farm

by Shaun Sommerer

The most common method of farm transfer has been the installment sale also known as "contract for deed." This method has been used so often that it has become the traditional way to pass a farm. Unfortunately, "contract for deed" may in fact be the worst possible way to transfer a farm for both the buyer and seller. How could this be?

Consider a "contract for deed" sale of a 500-acre farm worth $2,000 per acre (total sale price $1,000,000). From the buyers perspective, a 20-year installment sale at 8% interest will require annual payments of $101,825. In the first year the payment will require pre-tax income of $116,240 ($232.48 per acre). The pre-tax income required to make the annual payments steadily increases to a maximum of $164,724 ($329.48 per acre) in the 20th year. This increase is due to the fact that as the tax deductible interest payments decrease each year, the after-tax principal payments increase. Over the 20-years the buyer will pay $1,037,044 in interest plus $1,000,000 of principle and roughly $666,000 of taxes on the income required for the principal payments. This computes to an actual cost per acre of $5,407.42; nevertheless, the cost basis will still be $2,000 per acre when the farm is eventually sold.

From the seller’s perspective: if she/he places the principal portion of each installment payment in a "set aside" account each year, they will have $1,000,000 in their investment account at the end of the 20th year. The after tax amount of the interest payments from the installment sale and "set aside" account will provide an average spendable income of roughly $40,000 per year. This will start at $47,000 in the first year and decrease to $29,000 in the 20th year. "Cash rent" at $100 per acre on the other hand would generate a level spendable income of roughly $40,000 per year. The difference is that at the end of 20 years the seller has $1,000,000 in cash, received an average $40,000 per year in spendable income and paid $890,000 in income and capital gain taxes verses $210,000 in income taxes and they would still own the farm.

Ownership of the farm when the installment contract is signed and the seller’s income will be dependent upon the ability of the buyer to make the annual payments. If the buyer defaults, the seller could get the farm back. A contract for deed is a binding obligation on the buyer for the entire 20-year period.

One alternative to the "contract for deed" is to consider using a Charitable Remainder Trust (CRT). A CRT is a split interest trust meaning that the interest is split between the income and charitable remainder beneficiary (e.g., your parish). If the farm was gifted into a CRT, the CRT sells the asset but pays zero taxes. The entire $1,000,000 would become available to generate retirement income. There is potential for the Trust to generate nearly double the income compared to a traditional installment sale. The difference in income is due to the fact that the assets inside the CRT grow tax-free, while growth on the assets from an outright sale are taxed yearly. An additional benefit is that the assets of the CRT cannot be attached by creditors though the income stream can.

Transfer of a farm and asset conversion requires sound planning and professional advice. Be open to what might seem like "Non-traditional" vehicles such as a CRT if your estate, heirs and parish could benefit.