Is a contract sale still a good option?

Problem

In our current plan, we give our farming child an option to buy out their three siblings for 80% of fair market value on a contract. Our 800 acres were worth about $8,000 an acre when we did that, and now they are $15,000 per acre. The terms of the contract gave them the option to buy at our death on a 15-year note at the lowest allowable interest rate. Is this still a good way to keep our farmland together? - Submitted by email from K.B.

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Solution

Before I answer your question, K.B., let's see if math can help. The $8,000 per acre land at 80% equals $6,400. Your farm heir would inherit one-fourth and buy out three-fourths so the contract would essentially be for $4,800 an acre.

Using the terms you have outlined, their interest rate would have been about 2% at that time and the per-acre payment would have been $373 per acre. I am assuming that was OK.

Fast-forward to a year ago, land prices were already at $15,000. Using the same math and terms the payments would have jumped to $700 per acre.

Just in the past year, the main change to the formula would be the interest rates. Adding about three percentage points to the interest rate gets the payment to $867 per acre.

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Clearly, the combination of the land prices and interest rates nearly doubling creates a significant difference in your plan.

Do those numbers still work for the next generation? Some people assess this problem incorrectly. They approach it the same as leveraging the 800 paid-for acres to buy another 80 expensive acres. Your transfer plan doesn't work that way. The next generation would be buying 600 acres with only 200 inherited acres. That's a big difference.

We've grown accustomed to low interest rates. The recent spike in rates should be a huge wake-up call. It used to be that low interest rates meant higher land prices, or higher interest rates meant lower land prices. Now both land and interest rates are high, and possibly going higher.

Here are some solutions to consider:

• Start the contract now rather than at your death. Maybe reduce the purchase price more and spread it over a longer period. The lower purchase price may be considered a gift, but remember that you don't have to die to use your estate tax credit; you can use it while you're living. The challenge is determining what your other non-farming heirs will receive because the longer you live, the smaller the contract balance they will receive.
• Leave the terms as they are, but cap the land value at a "not to exceed" value. Rather than letting the land values be a runaway train with a price determined by an appraiser at your death, you can simply cap it at a buyout value that cash flows.
• Have life insurance in place to pay for a lump sum at your death so the other heirs are guaranteed to get something up front. That way, the balance is not so large nor does it drag out so long.

Some will say "As long as corn is over $6 a bushel, we will be OK." Brilliant, can you put that in the contract too? I don't think so. What happens if commodity prices drop $2 or $3 a bushel while land and interest rates are still up? Estate taxes may not kill your farm, but your own planning will.

Your problem can be solved, but something has to give or the land will be gone.