A reader just sent us the following question:

“If I had a parcel of farmland for sale, would I benefit by selling it this year 2010 or 2011? I was wondering how capital gains tax would affect what I would pay for both years?”

With the passage of the Tax Relief Act of 2010 late last night by Congress, this question has become even easier to answer.  The answer is that it does not matter from a federal tax standpoint whether you sell the land in 2010 or 2011.  The top capital gains rate for both years will be 15%. 

However, if you wait until January 2011 to sell the land, you are not required to pay the tax on the gain until April 15, 2012.  This gives you an extra year to invest the money and perhaps earn some interest (although in today’s interest rate environment, it may not be much).

Another consideration that you must check is if there are any major changes in state income law for your particular state.  Many states have an exclusion for sale of land, however, with the budget deficits that the states are facing, these exclusions may be reduced or eliminated.  Check with your tax advisor to see if the state law might make you want to do the sale in 2010 instead of 2011.

But for federal tax law, the rate is the same.

One of the newly proposed estate tax rules in the proposed tax act is the allowance of estates to combine both spouses lifetime exemption to maximize the estate tax savings.

Under current law, if the first spouse passes away and if their estate is less than the current lifetime exemption, the excess is lost forever.  For example, if a farmer passes away worth $2 million and leaves the farm to the spouse and then the spouse passes away with the farm worth $8 million dollars, the second estate will pay estate taxes on $3 million or about $1 million in total estate taxes (this assumes a $5 million lifetime exemption for both).

Now, under the proposed new law, when the second spouse passes away, the estate can combine the $3 million not used in the first estate plus the $5 million in the second estate.  This results in a total combined estate exemption of $8 million which is equal to the total value of the estate which means there is no estate tax owed.

As you can see, the new proposed law can easily save the estate $1 million or more.

The Senate is expected to vote on the bill by the end of this week and then send it to the house.  If the house simply votes on the bill as is, we should have the bill in place by Christmas.  However, if the House makes changes, we will most likely not have a bill until after Christmas and it may not become law until right after the first of the year or it may become caught up in the lame duck status of Congress at that time.

One of the recent issues of Cornhusker Economics put out by the University of Nebraska Department of Agricultural Economics showed how the farmland turnover for the current year is about half of the long-term trend.

The market for farmland has historically been a “thin” market in that very little is marketed and changes in ownership at any point in time are few and far between.

From an economics viewpoint, most people would predict that as prices rise, more and more product will be released into the market.  Farmland actually has the opposite happening right now.  As the price rises, farmers and investors are holding onto their farmland.

Since good farmland may remain in the same hands for decades, the window–of-opportunity is very limited to make a buy.

Over many decades, a rule-of-thumb has been anywhere from 3% to 5% annual turnover of ownership.  It is likely that the long-term trend is on the lower end, therefore, a particular piece of farmland will only be on the market once every 33 years.

The economics department reviewed all real estate transfer documents for Nebraska and eliminated any parcels less than 40 acres.  They then calculated a three year average for transactions in the 2006-2008 period.   These numbers were then divided by the total acres for each county to find out the turnover rate for each county in Nebraska.

They found that the average turnover for this period was 1.55% or an about 65 years between a particular piece of farmland coming up for sale.  Some counties were substantially under 1%.

Although this information relates to Nebraska only, I would surmise that most other states are seeing the same trends.

With a lot of recent discussion and articles on whether farmland prices are entering a “bubble” phase, I thought some analysis to see how a potential rise in interest rates might effect farmland prices would look like.

Farmland prices (as are most financial assets) is normally a function of the income generated by the farmland and the expected rate of return that an investor requires to make the investment.  Currently, farm income is historically high and interest rates are historically low.  With these two bullish patterns, farmland prices have enjoyed a large run up in price over the last ten years or so.

What if farm income stays high, but interest rates and the expected rate of return that an investor requires increases, how might this affect the price?

Let’s assume that we have an investor who owns 160 acres of very good farmland in Iowa that is currently worth $8,000 per acre and the cash rent on this property is $300 per acre.  This implies that the investor is willing to earn an approximate 3.75% rate of return.  Now let’s assume that the interest rates rise and the investor requires a 5% rate of return.  This would reduce the value of the property from $8,000 per acre to about $6,000 or a 25% drop in price.  If the required rate of return was 6%, then the price would be $5,000 or about a 37.50% drop in price.

This analysis assumes that cash rents would remain the same and other expectations would also remain constant.  However, normally, when interest rates rise, expectations change and the effect on prices could even be more dramatic than what is shown here.

If you are anticipating making an investment in additional farmland, make sure that you have done this analysis to determine the effect on your farming operation if rates and expected returns do rise.  Now is probably not the time to be making farmland purchases with much leverage.

I came across an article put out by the Center on Budget and Policy Priorities from Washington DC.  The gist of the article was that having an unlimed estate tax exemption for farm estates is unnecessary and likely harmful.  The focus of the article is that this policy would create 3 harmful situations:

1. First, according to the article, there is overwhelming evidence that the estate tax does not pose a significant problem for farmers.  The Urban Institute-Brookings Institution Tax Policy Center estimated there would be fewer than 110 small farm estates for 2011 if we used the 2009 estate tax exemption of $3.5 million (their definition of small farm estate is less than $5 million in assets or less than 1,000 acres of good Iowa farmland).
2. Second, an unlimited exemption for farmland would promote tax sheltering by giving wealthy individuals whose primary occupation is not farming a strong incentive to sell financial assets and purchase large tracts of farm land to avoid paying the tax.
3. Third, an unlimited farmland exemption could hurt ordinary farmers by driving up the price of farmland as wealthy individuals buy farmland for use as an estate tax shelter.  This would make it harder for young aspiring farmers to enter the farming industry and for families to hold onto true family farms.

Remember that these are their conclusions, not necessarily mine.

My comments are as follows:

• They stated that estate tax opponents have not been able to come up with one case where the estate tax forced a family farm to be sold.  I would be curious to hear from my readers if they have any experience of a family farm being sold because of the estate tax.
• Their definition of a small farm being less than $5 million in today’s environment very likely understates what I would consider to be a family farm anymore.  Many typical family farms these days have at least 1,500 to 2,000 acres of owned land plus equipment and other non-farm assets.  This could very easily result in a taxable estate of $10 – $15 million or more.  Under this scenario, the estate tax using 2009 rates could be in excess of $5 million.
• There are several estate tax provisions to reduce or defer the amount of tax that a farm family would owe, but these items have not been indexed with inflation and the value has decreased dramatically with the rise in farmland prices.
• The one conclusion that I probably agree with the most is that it would promote a desire by wealthy families to invest substantially in farmland to escape estate taxes.  This would drive up the value of farmland leading to much higher cash rents, etc.  I would not be in favor of exempting only farmland for that reason.  If all small businesses were exempted, then the effect would be much more minor.

My personal opinion is that I would like to see an estate tax exemption in the $3.5 to $5 million range for each spouse and allow this exemption to be combined in any manner that the family chooses.  We will most likely see a new estate law sometime in the next year or so, but who really knows what it will look like.

As you can probably guess this headline that the answer is – “It Depends”.  Iowa State University economist Mike Duffy ran some numbers comparing the return from owning farmland to owning stocks over certain time frames.

Returns are comprised of two components:

1. Yearly return – Cash dividends on stocks and cash rents (or the equivalent on farmland), and
2. Change in market values

Mr. Duffy assumed that a farmer invested in land on January 1, 1960 paid $1,000 or the equivalent of 3.83 acres.  He also assumed a farmer bought 17.60 shares of the S & P 500.  The farmer then took his net cash return (after 7% for management fees and 6% for taxes and insurance) and reinvested it in more land each year.  At the end of 2009, the farmer would have owned 32.87 acres worth about $143,672.  He would have owned about 75.58 shares of the S & P 500 worth about $83,805.  The land outdid the stocks by about 72%.

However, Mr. Duffy then redid the analysis assuming purchase of farmland on January 1, 1980 (at almost the last farmland value peak).  In the scenario, the farm would have only grown to a total value of $8,314 whereas stocks would have grown to $17,365.  The land would only be worth about 48% of the stocks.

What will the next 20 or 40 years bring.  With the high value base of farmland and the lower base of common stocks, it may be hard for farmland to outdo stocks, but it may be more rewarding to own the land than a piece of paper.

For the article, click here.

I have written many times about how farmland has been a good investment for at least the last 10 years or so.  Most of this data has been gathered from sources directly related to farming, however, I have started to notice a trend about reporting on farmland as an good investment in mainstream sources such as Business Week. 

This trend continues with a recent article in the Wall Street Journal about buying farmland for income.  The article indicates that by buying farmland, an investor should receive a current 3-5% yield plus up to another 5% in annual price appreciation over the term of the investment.  This comes from R. Dennis Moon with US Trust, a unit of Bank of America.

One of the challenges right now is finding quality land.  The supply is smaller than usual since farmers and their heirs are keeping the land they otherwise might have sold, in order to book the rental income.  The number of qualify farmland for sale appears to be down about 30-40% according to Loyd Brown of Hertz Farm Management, Inc. of Nevada, Iowa.  Even medium quality land is down by this amount.

Now that these articles are now starting to appear in main-stream sources, my contrarian sense is that farmland may be starting to peak as an investment for investors.  This may end up being good for farmers if the speculative pricing gets eliminated from land values.  We can wait and see how it turns out.

I try to skim a few of the major Mid-West farm cities and the Omaha World-Herald recently had an article on how food demand is driving farmland prices higher.  There was a regional conference in Omaha sponsored by the Federal Reserve of Kansas City.  The meeting brought forth various good nuggets of information about the rising demand for food and how it is affecting farmland prices.

In 2005, the world produced about 7 billion tons of food which is about on average a ton of food per person on the earth.  By 2030, which is only 20 years away, rising population will require another 3-4 billion tons of food to be produced.

This strong increase in demand encourages long-term investors to realize that good farmland is already in production and only marginal farmland will come into production over the next 20 years or good farmland will be taking away by suburban growth.  According to the speakers, this demand will cause farmland prices to continue to increase.

Farmers National Co. of Omaha reported that recent sales of good quality farmland reached $8,000 an acre in Illinois, $7,500 in Iowa and $7,000 in Nebraska.  Demand is high for ground that can grow corn and beans and prices are up since there is so little ground is for sale.

Even grassland values are drawing higher prices.  For example, grassland sold neer O’Neill, Neb. recently sold for $580 per acre, substantially higher than the recent sales range of between $385 and $450 per acre.

As more people in the world move from rural to urban areas, their demand for animal products will increase.  One of the drawbacks of this move is that a pound of beef requires 1,800 gallons of water to grow while a pound of wheat only requires 180 gallons.  We will have to use water more efficiently in the future than we are now to keep up with this demand.

While many factors point toward health agricultural growth, there are serious challenges, including an imbalance in labor, environmental concerns, unwise public policy decisions in some countries and higher food prices that strain developing countries budgets.

One of our readers sent me an e-mail yesterday regarding an article posted by www.farmgate.com regarding the return on farmland investment from 1970 top 2009.   This post was based upon the research done by Iowa State University.

Over the years farmland investment have yielded a very competitive rate of return compared to other investments.  However, about half of the return comes from appreciation in land, which can be unpredictable and it does not provide any cash to cover expenses or mortgage payments.

This research broke down the years between four distinctly different periods:

• The farm boom period from 1970 to 1981,
• The farm crisis from 1982 to 1987
• The recovery period from 1988 to 2003
• The Ethanol Boom from 2004 to 2009

During the farm boom period, an average farmer enjoyed 7.3% average cash rent return on their land and their land appreciated in value from an average of $392 per acre to $1,941 per acre or an average return of about 14.3%.  Therefore the total average return for this period was about 21.6%.

During the farm crisis, the average cash rent was actually at the highest average of about 8%, however, this was due to the decrease in land prices.  During this period, land values decreased from $1,941 per acre to about $786 per acre or an average negative return of (14%), which about wiped out the returns during the farm boom.  Overall average returns during this period was a negative (6%).

During the recovery period, average cash rents were about 7.25% and land prices increased from about $786 to $2,010 or an average increase of about 6% or a total annual return of 13.25%.

Therefore, the overall return during the 40 year period wsa about 6% from appreciation and 7% from cash rents for an overall annual return of 13%.

During the Ethanol Boom, the average cash rents was the lowest at about 4.4%, but the increase in price from $2,010 to $3,850 or 11.4% equals an average annual return of about 15.8%.

The best cash rent return was 9.6% in 1987 at the peak of the farm crisis and worst return was 2008 at 3.8% during the Ethanol Boom.  The best appreciation year was 1977 at 36.8% and the worst was 1985 at a negative 28%.

The Federal Reserve Bank of Kansas City issued their quarterly report on agricultural credit conditions for the first quarter of 2010.  They indicated farmland values rose due to strong demand and the rebound in livestock prices.  Both farmer and non-farm demand appears to be very good.  Looking ahead, they expect farmland values to hold steady.

However, most district bankers reported that farm income fell slightly in the first quarter, however, they expect higher levels in the second quarter with the year being steady.

Farmland values for the quarter rose about 2% with Nebraska having the highest gains of about 6%, however, Oklahoma and the mountain states were lower for the quarter.  This was the strongest gain in over a year primarily due to the livestock rebound.  Interest rates edged down slightly, averaging 6.6 percent.

In reviewing the long-term chart shown in the report, there have only been 3 quarters that have been negative since 1990.  Two quarters were in late 1990 when the Internet bubble was at its highest and one quarter last year.   Owning farmland has been a very good investment over the last 20 years.  We all hope the trend continues for the next 20 years.