Special Use Valuation

"Highest and best use" valuation. Property must be valued at its fair market value for purposes of the estate tax. In turn, unless there is a specific exception, fair market value normally is determined by a property's "highest and best use," that is, the use that would make the property the most valuable. This is true even if the property currently is not being employed in its highest and best use. For example, if the deceased was using a gold bar as a paperweight, you'd have to base its value on the price of gold per ounce, not on the going rate for heavy paperweights.

Farms and closely held businesses. A significant exception to the "highest and best use" rule applies to closely held farms and other family-owned businesses. Congress enacted this provision to help ensure that the family farm did not have to be sold to pay estate taxes calculated on the property's "highest and best use" as a residential or commercial development. In order to qualify for this valuation, the following requirements must be met:

• The decedent must have been a resident or citizen of the United States.
• The property must pass to a "qualified heir." This is defined as the decedent's spouse, his descendents or their spouses (such as son, daughter-in-law, greatgrandson), his ancestors (such a parents or grandparents), and the lineal descendents of his spouse or parents.
• A recapture agreement must be filed with the IRS. As part of the agreement, the qualified heir must agree to be personally liable for any additional estate tax due to if the property is no longer a family farm or closely held business or if the property is sold
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• The property must a qualified farm or closely held business on the date of the decedent's death.
• The decedent or a member of the decedent's family must have owned the qualifying property and have materially participated in the operation of the farm or other business for within an eight-year period.
• The adjusted value of the real and personal property used in the farm or closely held business must account for at least 50 percent of the adjusted value of the decedent's gross estate.
• At least 25 percent of the adjusted value of the gross estate must be qualified real property.

If all the requirements are met, the property will be valued in accordance with its actual (current) use. However, this special use valuation tax break can not reduce the decedent's federal gross estate by more $1,070,000 in 2013. (The limit is annually adjusted for inflation.)

The operation of the special use valuation limit is illustrated in the following example:

Example The estate of Fred Farmer, who died in 2013 contains qualifying real property valued at $1,400,000 based on its "highest and best" use. The same property's value calculated under the special use valuation provision is $300,000. Although the difference between the two valuations is $1,100,000, the maximum reduction allowed is $1,070,000 (i.e., the limit for 2013.)

If you believe your estate could benefit from this special use valuation, then work with an estate planning professional to make sure that all the requirements are met and your heirs are protected.