Current use valuation allows a farm estate that transfers to qualified heirs and is continually farmed to be valued at the use value and not the market value. A qualified heir includes the decedent's ancestors as parents or grandparents; the decedent's lineal descendants as children and grandchildren; the spouse; lineal descendants of the spouse, including stepchildren; and descendants and spouses of the decedent's parents, including sisters, brothers, and nieces or nephews. Discretionary trusts qualify if all beneficiaries are family members. Cousins, aunts, and uncles of the decedent are excluded. Only real property is eligible for use valuation.

The Tax Reform Act of 1976 did not clearly define how to determine use value. A "multiple factor" method and a "farm method" were established. The farm method formula is calculated by subtracting state and local real estate taxes from the average annual gross cash rental or net share rentals for tracts of comparable land divided by the effective interest rate for all new Federal Land Bank loans. Net share rentals can be used if the executor cannot identify comparable cash rental property in the same locality. For timber land, rental rates are usually nonexistent, and other methods of capitalizing income must be used or comparable sales data must be found.

Current use value = [(5-year average of gross cash or share rents for comparable land) - (5-year average of real estate taxes)] divided by Average effective interest rate for new Federal Land Bank loans

Two examples illustrate the differences that may occur in use values and fair market values:

If the executor, after agreement from all heirs, elects to have property valued at current use value, the gross estate cannot be reduced by more than $750,000. The special use valuation election must be made when the decedent's estate tax return is filed, regardless of whether this is a late return or one filed within nine months of death.

To qualify for special valuation, the property must have been farmed and must continue to be farmed. This includes land in forestry. Timber land and standing timber qualify, but if the standing timber is cut before the 10-year recapture period expires, the difference in market value and use value has to be paid plus interest as a late estate tax payment.

These are conditions that must be met before a farm qualifies:

1. At least 50 percent of the adjusted gross estate must be comprised of real or personal property devoted to the farm.
2. At least 25 percent of the adjusted gross estate must be "qualified" real property.
3. Property must pass to a qualified heir.
4. The real property must be used or held for use in the farm business for five of the last eight years before the decedent's death, retirement on social security, or disability.

The retirement date is the date the farmer starts receiving social security retirement benefits. Disability means a mental or physical condition that lasts until death and prevents the farmer from actively farming. Qualified use requirements can be met if family members farmed the land before the decedent's death. A two-year grace period is allowed after the decedent's death (regardless of the five- or eight-year rule) before a qualified heir has to begin using the property to avoid recapture of the tax savings.

If property passes to the decedent's spouse, a qualified heir who is a full-time student, a qualified heir under 21 years of age, or a qualified heir who is disabled, that person needs only to participate in the "active management" of the farm for the property to maintain its special use valuation status. Active management means making business decisions other than the farm operating decisions.

If property passes to other qualified heirs, "material participation" is required. This is generally determined by the level of management, physical work, decision making, furnishing livestock or equipment, and assuming some financial risk. All these activities are not required for material participation to exist. Although there is no precise definition of material participation, involvement in operating decisions is important.

A qualified heir can buy real property from an estate without affecting the special use valuation of that property. Tax has to be paid only on the difference in value at decedent's death and the value at the time of the sale. The heir who buys the property, however, must take the special use value as his basis for the property.

Current-use-valued property can be exchanged for like-kind property. This exchange is allowed if the trade is for property with the same qualified use. Property received in a trade or bought to replace involuntarily converted property can be valued at use value with the same rules applicable to the recently acquired property.

All property valued at current use value is subject to a 10-year recapture period. The property must remain in the current use or farm use for 10 years or there will be a recapture of all the tax savings. This 10-year period is extended by 2 years if the heir used the 2-year grace period before beginning farming operations.

Normally, property passed to an heir has an income tax basis equal to the market value at the time of death of the decedent. When there is a sale, tax is paid on the difference in the sale price and the basis. If the property passed to an heir is valued at use value, this value becomes the basis. Thus, a tax would be higher on the current-use-valued property because of the lower basis.

The complexities of using special use valuation increase the need for expert accounting and legal help.