Rev. Rul. 88-78

1988-2 C.B. 330, 1988-38 I.R.B. 13.

                       Internal Revenue Service

                                 Revenue Ruling

                  SPECIAL USE VALUE; FARMS; SUBSURFACE RIGHTS

                         Published: September 19, 1988

SECTION 2032A. - VALUATION OF CERTAIN FARM, ETC., REAL PROPERTY, 26 CFR 20.2032A-3: Material participation requirements for valuation of certain farm and closely-heldbusiness property

  Special use value; farms; subsurface rights. Three situations consider the section 2032A(c) of the Code recapture tax consequences of the development of subsurface oil and gas interests in farm property that is subject to a special use valuation election under section 2032A(a).

  Rev. Rul. 88-78 involves three situations. In Situation 1, an individual owned and operated a farm for several years. In 1981, the individual granted a leasehold interest in the farmland for oil and gas in place to an unrelated oil and gas operator. The individual retained a one-eighth royalty interest and a fee simple in the farmland. The individual received royalties until his death in 1983, at which time the individual's child was bequeathed the entire estate. The farmland, excluding the royalty interest, was worth $500,000 when the original owner died. The deceased individual's estate properly elected section 2032A special use valuation and reported as separate real estate assets the farmland having a special use valuation of $200,000, and the retained oil and gas royalty interest, which had a fair market value of $150,000. Though drilling had permanently prevented a small portion of the farmland from being cultivated, the decedent's child continued to farm the rest of the property and to collect royalties. The child sold the oil and gas royalty interest in 1987.

  The facts in Situation 2 are the same as in Situation 1, except that no leasehold interest for oil and gas had been granted by the decedent. Drilling in the local vicinity had been successful before the decedent's death. Consequently, the estate included as separate real estate assets the farm property at a special use valuation of $200,000 and the potential oil and gas deposits at a fair market value of $25,000. After the decedent's death, the child granted an oil and gas lease, and a successful oil well was completed.

  Situation 3 is the same as Situation 2, except that as of the date of the decedent's death, there was no evidence indicating a likelihood of oil or gas deposits beneath the farm. Accordingly, the estate reported only the special use valuation of the farm under section 2032A. It did not provide a separate valuation for potential oil deposits.

  ISSUE. At issue is whether the grant of a lease in subsurface oil and gas interests, the extraction of the oil, or the disposition of royalty rights, with respect to specially valued farmland, constitute a disposition of specially valued real property that would result in the recapture tax under section 2032A(c)(1)(A) or (B).

  HOLDINGS. The Service has held that the grant of a lease in subsurface oil and gas interests, the extraction of the oil, or the disposition of royalty rights do not constitute dispositions of specially valued real property for recapture tax purposes, because the oil and gas interests were not includable as part of the farmland that can be specially valued under section 2032A. The Service held, however, that to the extent specially valued farmland is subsequently used for oil drilling and gas extraction in Situations 1 and 2, a cessation of use of specially valued farmland has occurred for recapture tax purposes.

  ANALYSIS. The key to the Service's holdings was how the estate treated the farmland at the date of the decedent's death. In Situation 1, the Service noted, the estate properly reported the farmland and the mineral rights as separate real estate assets, including the mineral rights at their fair market value. Consequently, when the decedent's child sold the royalty interest, there was no disposition of specially valued farmland and the recapture tax is not triggered.

  Situation 2, like Situation 1, saw the estate properly treat the farmland and the mineral potential as two assets, with the oil possibilities valued at their fair market price. When the child disposed of those rights, no recapture tax is required, the Service said, except to the extent that specially valued farmland is used for oil drilling and gas extraction.

  Finally, in Situation 3, separate reporting and valuation was not required since no oil was suspected until after the decedent's death. Nevertheless, to the extent that the child's disposition of mineral rights causes specially valued farmland to be used for oil drilling and gas extraction, recapture tax will be required, the Service held.

                                     ISSUE

  Does the grant of a lease in subsurface oil and gas interests, the extraction of the oil, or the disposition of royalty rights, with respect to farmland that is specially valued under section 2032A of the Internal Revenue Code, constitute a disposition of specially valued real property for purposes of the recapture provisions contained in section 2032A(c)(1)(A) or (B)?

                                     FACTS

                                  SITUATION 1

  The decedent, D, owned and operated a farm for many years, raising a variety of agricultural crops. In 1981, D granted a leasehold interest in the farmland for oil and gas in place to X, an unrelated oil and gas operator. D retained a one-eighth royalty interest, as well as the fee simple in the farmland. The operator drilled and completed an oil well and, during the two years before D's death, D received oil royalty payments. D died in 1983, devising and bequeathing the entire estate to D's child, C. At D's death, the farmland, excluding the royalty interest, was worth $500,000. The farmland qualified for special use valuation as qualified real property under section 2032A of the Code. D's executor properly elected special use valuation and included on Form 706 (the federal estate tax return) as separate real estate assets the farmland at a special use valuation of $200,000 and the retained oil and gas royalty interest at a fair market value of $150,000. The drilling and extraction activities had permanently prevented cultivation of a small portion of the property. Consequently, that portion was not reported for federal estate tax purposes as qualified real property. That portion of the property was included in the gross estate for federal estate tax purposes as part of the royalty interest valued at its fair market value rather than at a special use value. After D's death, C operated the farm continuously and collected all oil royalties. In 1987, C sold the oil and gas royalty interest.

                                  SITUATION 2

  The facts are the same as set forth in SITUATION 1, except that no leasehold interest for oil and gas in place was granted by D. After D's death, C granted an oil and gas lease, and a successful oil well was completed. At the time of D's death the extent and value of the oil deposits were unknown, although oil wells had been drilled successfully elsewhere in the vicinity. D's executor included on Form 706 as separate real estate assets the farm property at a special use valuation of $200,000 under section 2032A of the Code and the potential oil and gas deposits at a fair market value of $25,000.

                                  SITUATION 3

  The facts are the same as in SITUATION 2, except that, as of the date of D's death there was no evidence pointing to the likelihood of oil or gas deposits beneath the farm. D's executor included on Form 706 only the special use valuation of the farm under section 2032A of the Code at $200,000. There was no separate entry on the Form 706 for the value of any potential oil deposits.

                                LAW AND ANALYSIS

  Section 2032A of the Code permits an executor, in determining the value of a decedent's gross estate, to elect to value farm or other trade or business property on the basis of its value for its qualified use in farming or the other trade or business rather than on the basis of its highest and best use.

  Section 2032A(d) of the Code provides that the election under section 2032A shall be made on the federal estate tax return. Such an election, once made, is irrevocable.

  Section 2032A(c)(1) of the Code provides that if, within 10 years after the decedent's death and before the death of the qualified heir, the qualified heir (A) disposes of any interest in the specially valued property to a person other than a member of his family, or (B) ceases to use the property for the qualified use, an additional estate tax will be imposed in the form of a recapture tax.

  Section 2032A(c)(2) of the Code describes the amount of the recapture tax imposed with respect to any interest. This recapture rule applies under section 2032A(c)(2)(D) to partial dispositions of the specially valued property or to cessation of the use of a portion of that property. Section 2032A(c)(2)(D) states that where the qualified heir disposes of a portion of the interest acquired by such heir or there is a cessation of use of such a portion -

  (i) only the pro rata portion of the value determined under section 2032A(a) is taken into account in applying the formula to determine the recapture tax, and

  (ii) the adjusted tax difference attributable to the interest taken into account with respect to the transaction involving the second or any succeeding portion shall be reduced by the amount of the recapture tax imposed with respect to all prior transactions involving portions of such interest.

  Under section 2032A(c)(6)(A) of the Code, real property that was specially valued for the qualified use of farming ceases to be used for that qualified use if, within the recapture period, the property is no longer used for farming purposes.

  The interest of a lessee in oil and gas in place is an interest in real property for federal income tax purposes. Rev. Rul. 68-226, 1968-1 C.B. 362, superseding I.T. 3693, 1944 C.B. 272 (to the same effect). In addition, a royalty interest in oil and gas in place is a fee interest in mineral rights and real property for federal income tax purposes. Rev. Rul. 73-428, 1973-2 C.B. 303. Based on the rationale in Rev. Rul. 68-226 and Rev. Rul. 73-428, the disposition of oil rights is the disposition of an interest in real property.

  The Ways and Means Committee Report, H.R. Rep. No. 1380, 94th Cong., 2d Sess. 24 (1976), 1976-3 (Vol. 3) C.B. 735, 758, states that 'elements of value which are not related to the farm or business use (such as mineral rights) are not to be eligible for special use valuation. For example, if there is an oil lease on a farm, the full value of the mineral rights is to be taken into account for estate tax purposes.' Because mineral interests are not interests that are specially valued as part of a farm, they must be valued as any other asset in the decedent's estate. Sections 2031 and 2033 of the Code provide that the value of the decedent's gross estate shall include the value of all property to the extent of the decedent's interest therein at the time of death. Section 20.2031-1(b) of the Estate Tax Regulations defines value as the fair market value at the time of decedent's death. Fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.

  In SITUATION 1, the farm qualified for special use valuation even though it was subject to a pre-existing lease for oil and gas in place. The oil and gas royalty rights were properly reported on Form 706 as separate real estate assets and included at a fair market value of $150,000. The gross estate included the fair market value of the royalty rights at the date of death of the decedent and the royalty rights were not specially valued under section 2032A of the Code. Therefore, although the extraction of oil in conjunction with the receipt of royalties represents the disposition of a valuable component of the farmland, it is not a disposition of an interest in the specially valued real property in this case. Similarly, although the sale by C of the right to receive oil and gas royalty payments in 1987 is a disposition of an interest in real property for federal income tax purposes, this sale is not a disposition of an interest in the specially valued real property either. Thus, this disposition does not trigger the recapture tax under section 2032A(c)(1)(A).

  In SITUATION 2, although the value of oil deposits was unknown at the time of D's death, the estimated value of possible oil deposits was properly reported as a separate real estate asset on Form 706. Since this asset was severable from, and not part of, the specially valued farm property under section 2032A of the Code, it was separately valued at its date of death estimated valued. Any subsequent disposition of interests or rights in the oil deposits would not be a disposition of an interest in specially valued real property under section 2032A. Therefore, no additional tax would be imposed under section 2032A(c)(1)(A).

  In SITUATION 3, no oil had been discovered or was suspected to exist until after the decedent's death. Under the circumstances, no separate value of mineral rights was reported on Form 706. Therefore, a post-death discovery and disposition of interests or rights in oil deposits cannot trigger the recapture tax under section 2032A(c)(1)(A) of the Code because it is not a disposition of an interest in the specially valued real property.

  However, well-drilling activity and the subsequent extraction process normally would interrupt farm operations on a limited area of the farm. In SITUATION 1, the farmland permanently affected by such interruption was not part of the property included in the special use valuation under section 2032A of the Code. In SITUATIONS 2 and 3, a cessation of qualified use occurs for purposes of section 2032A(c)(1)(B) to the extent farmland that is treated as qualified real property is subsequently used for oil drilling and extraction.

                                    HOLDING

                                 SITUATIONS 1-3

  The grant of the leasehold interest for oil and gas in place, the extraction of the oil, or the disposition of the oil and gas royalty rights does not constitute a disposition of specially valued real property for purposes of the recapture provision contained in section 2032A(c)(1)(A) of the Code, because oil and gas interests are not includible as part of farmland that can be specially valued under section 2032A. However, to the extent that specially valued farmland is subsequently used for well drilling and extraction in SITUATIONS 2 and 3, this constitutes a cessation of use of specially valued farmland for purposes of the recapture provision in section 2032A(c)(1)(B).

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Suzanne Reynolds of the Individual Tax Division. For further information regarding this revenue ruling, contact Ms. Reynolds on (202) 566-8908 (not a toll-free call).

Rev. Rul. 88-78, 1988-2 C.B. 330, 1988-38 I.R.B. 13.