Legal Aspects of Indiana Farmland Leases
and Federal Tax Considerations *
Recent years may have been among the most tumultuous in the farmland lease market in many years. A dramatic farm program change in April of 1996, provided cash-rent tenants a "bonus" the first "Freedom-to-Farm" payment. Also, corn and soybean price expectations increased during 1996.The stage was set for a rise in crop land rents - tenants out-bidding their neighbors, and landlords seeking a part of the "Freedom-to-Farm" payment, and a part of the expected increase in crop income.
Now there may be an upheaval in the farmland lease market arises due to unexpected low commodity prices. Rent adjustments may depend upon the agreement for recent years. That is some rents may be too high or too risky for the tenant, and others may not depending on whether the parties ever adjusted the rent following the advent of the current government program. Many tenants and landlords may be looking for a new lease with features to deal with increased risk and uncertainty. For assistance with developing flexible lease and rental terms, see Howard Doster's paper What is the Right Rent?
When there is dissatisfaction with a lease, problems arise, e.g., confusion over lease termination rules, or whether a termination notice is required. What are the rules that control farmland leases? Can the law and legal tools protect the interests of tenants and landlords?
What are the basic elements of a lease? Few words are needed for a valid lease. Basics include the following information:
a. Date of making the lease.
b. Names and addresses of the landlord and tenant.
c. Description of the leased property.
d. Period or crop year(s) covered by the lease.
e. Cash rent or shares of cash costs and crop share and resource contributions of a landlord and a tenant.
f. When and how rent is paid.
g. Signatures of the landlord and tenant.
Many other provisions may be in a farmland lease. These include:
h. Notice requirement for termination of the lease.
i. Restrictions and requirements for the use of the land and facilities - increased importance due to environmental law concerns.
j. A formula for reimbursing a tenant for multiple-year applications of crop nutrients when a tenant is terminated or decides to give up the lease.
k. Reimbursement rules for completed fieldwork or for a crop already growing when a lease is terminated.
l. Landlord's right to a security interest in crops or other provisions for insuring the cash rent or crop share.
m. Provisions for mediation or arbitration of disputes.
Tenants and landlords may include many other provisions in a lease to fit the situation. It is wise to include all important considerations and concerns in the lease.
Fundamentals of Farmland Lease Law
Are oral leases legal? Historically, many farmland leases have not been in writing. Oral leases of farmland are enforceable in Indiana. While transactions in real estate are generally required to be in writing, an Indiana statute permits an oral lease extending up to three years. (See IC 32-2-1-1). That is, disputes arising over the terms of an oral lease, not exceeding three years, may be introduced into evidence in an Indiana court. [Indiana Code (IC) may be located by entering up to four numbers of an IC cite. Selected sections relating to leases are listed below in Appendix A ]
Proving the specific terms of an oral lease may be difficult unless there was an unbiased witness to the agreement. When an issue was not discussed or agreed upon in an oral or written lease, custom of the community may be introduced in court to settle a dispute.
Leases longer than three years must be in writing to be enforceable in an Indiana court. Long-term leases should be recorded to protect a tenant against future lessees, buyers and creditors of the landlord.
Lease Termination Notices. How much advance notice is required to terminate a farmland lease? If the lease (oral or written) includes no termination provisions, an Indiana statute requires a notice three months prior to the end of the lease year. Historically, the crop year begins on March 1. Thus, under the three-month rule, if the lease year ends on the last day of February (of the following year), the notice would be timely if delivered before December 1 (of the current year). While many leases may have been terminated by an oral notice, the law appears to favor a written notice when a notice is required. What is included in a notice is in IC 32-7-1-4 shown below in Appendix A
End of a Lease Year. The Indiana Code does not provide the date for the end of a lease year. A lease ending date may be determined from the initial beginning of the lease or from an understanding between the landlord and tenant. The custom of March 1 as the possession date for farmland may be difficult to support though it may be the "custom of the community." Thus, it is wise to have a written agreement covering the lease term.
Notice five to six months before the traditional March 1 date may be fair to a tenant and a landlord, and promotes good management. If the new provision for FTF advances after Oct. 1 of the current year becomes permanent, leases for the following year should be settled by the end of September of the current year.
Term Leases. Leases may be for a specific term (date to date), usually for a year, and require no termination notice. [See Indiana Code Section 37-7-1-7]. Term leases are usually in writing, but they may also be oral. A term lease may encourage a discussion about needed adjustments in a lease, since there is no lease for the following year until there is a new agreement.
No Discussion May Mean Approval. If a tenant remains in possession of the leased property, he or she may have a lease on the same terms as the prior year. In subsequent years, the tenant may be entitled to a three-month advance notice to terminate, unless he or she agrees to a term lease.
An outgoing tenant's rights in growing crops. An outgoing tenant has a right to growing crops (emblements) if three conditions are present:
a. The tenancy was of an uncertain duration.
b. The tenant was terminated due to no fault of his or her own.
c. The crop was planted by the tenant.
The"doctrine of emblements" says the tenant who planted the wheat, and then was legally terminated before the crop matures has (1) a right to harvest the crop for his or her share under the lease, or (2) be provided the returns from the crop less the expenses of harvest and transport of the crop to market.
It seems a logical and fair extension of the doctrine of emblements that if a tenant continues in good faith until a lease is terminated, he or she should be fairly compensated for the expenses incurred and to profit from a growing crop. However, the law has a policy that it is folly for a tenant to plant when he or she has no assurances of a right to harvest.
The doctrine of emblements might also support a tenant who leaves mature crops at the end of the lease if there is a good excuse for not having completed harvest. Unusual weather or a tenant disability may be examples of sufficient alibis.
Another legal doctrine, unjust enrichment, might favor a tenant. This doctrine is based on the premise that one party should not benefit at the expense of another.
Should a landlord obtain a lien? A landlord may want to obtain a lien or security interest in a tenant's crops. Many feel that in case of a tenant's financial stress, and perhaps bankruptcy, a landlord with a share lease has a clear right to his or her portion of the crop as opposed to other creditors who may have a security interest in a tenant's crops.
It seems logical that a tenant's creditor should not be able to take a security interest (lien) in a landlord's crop share without his or her permission. However, in common law, a tenant owns the entire crop until it comes out of the field even for a share lease.
The best strategy may be for a landlord to obtain a Uniform Commercial Code (UCC) security interest in the crop to be grown on his or her land as a condition of the cash rental arrangement. In Indiana, since December 1986, there is a requirement to give the potential buyers of a tenant's crop notice of a UCC lien. This notice should insure a joint check for crop proceeds - to the tenant, and all creditors who have given notice of a lien in the crop. [Note, UCC liens require several steps to be effective.]
If a tenant has other creditors with a lien in the crop to be grown on a landlord's land, a landlord may ask a tenant's other creditor(s) to subrogate to a landlord's interest.
A landlord might require advance payment of the entire cash rent. Alternatively, he or she may require a letter of credit (which guarantees payment of the rent) from a tenant's banker or other primary lender when the above alternatives are not practical or do not provide sufficient assurances. Lastly, when a landlord in Indiana expects his or her rent is in jeopardy, he or she may obtain a statutory landlord's lien.
This statute requires a courthouse filing at least 30 days before the crop matures, but during the year the crop is growing. A landlord's lien has priority over liens filed or obtained later, including subsequent UCC liens. It will be inferior to prior UCC liens, and is avoided in bankruptcy. A landlord's lien does not require the consent or knowledge of a tenant. A landlord's lien is better than no lien at all and may be adequate protection if his or her tenant does not go into bankruptcy.
Federal Tax Issues
A landlord's involvement in the farming operation via the lease matters for income, self-employment, and federal estate tax purposes. Generally, a tenant is a farm business, and will report his or her net farm income and expenses to the Internal Revenue Service on Schedule F. A sole proprietor/tenant will pay self-employment (SE) tax on his or her net farm income.
Share Leases and Material Participation. Material participation (MP) was originally placed into the tax law as a criteria by which to establish whether a landlord was liable for self-employment tax on net farm returns. (See the Farmer's Tax Guide, IRS Publ. #225, for the alternative material participation tests.)
For example, a landlord may satisfy one of the MP tests with a share lease with which he or she reserves and exercises authority over decisions made throughout the year (such as, what to plant and whether to treat for a crop insect infestation). When materially participating, a landlord has veto power over key production decisions.
And, a landlord must also inspect and observe production activities periodically. An agent (e.g., a farm manager) cannot perform MP tasks for a landlord. However, a farm manager may assist a landlord who is materially participating. A landlords who is materially participating in a farming business, will report income and expenses on Schedule F, and pay the SE tax.
It should be stressed that a crop-share lease need not involve material participation by a landlord. If it does not, a crop-share landlord reports his or her farm income and expenses on the Form 4835. In this case, there is neither a requirement nor an entitlement to pay the SE tax.
A widely circulated myth about Social Security retirement is that it is necessary for the retiring landowner or farmer to rent his or her land for cash. Clearly, a crop-share will be okay as long as it is clear that the retiree does not materially participate. MP income is active income for SS retirement purposes while non-MP, crop-share income is not- just as cash rent income generally is not.
Earned Income in Social Security Retirement. A landlord's MP income counts toward the maximum amount of income that he or she may earn before Social Security retirement benefits will be reduced under the "annual earnings test." This test applies until the SS retiree reaches age 70. [There is a "monthly test" for the first year of a Social Security retirement. A prior (pre-retirement) year's crop sold from inventory does not count as income for the monthly test though the sales may be subject to the SE tax.] After an individual on Social Security reaches age 70, earned income does not cause a potential offset against, SS retirement benefits.
Cash Rent Is Unearned Income. In contrast, the cash rent lease, generally, is not a materially participating arrangement. The income to a cash-rent landlord is"unearned income," which is reported on a Schedule E. Just as for a non-materially participating landlord with a crop-share lease, generally, SE tax is not normally due on cash rent income.
When non-material participation status is desired, a lease may clearly indicate that a landlord does not have farm operating or other decision-making powers during the production period. However, not materially participating does not prevent a landlord from dictating in the terms of a rental agreement or crop-share lease much of what will happen on his or her land during the crop year.
Estate Tax Considerations. Material participation is also a consideration for farmland owners or farmers being qualified for estate tax savings. Special use valuation (SUV) of farm and ranch land allows up to a $750,000 reduction in land value to be included in a decedent's estate. SUV requires an MP period. However, a landowner may maintain SUV eligibility with a cash rental to a "family member." A family member may satisfy both the MP and an "at risk" requirement. Generally, to be at risk requires a share lease.
A new, Family-Owned Business Interest Deduction (FOBID) permits the deduction of up to $675,000 of qualified business interest from a deceased farmer=s estate tax estate. Generally, to qualify, a deceased farmer must have been running a "trade or business." For a tenant this is not much of an issue, but a landowner who is renting the land and facilities, material participation as explained may be sufficient to meet the "trade or business" requirement.
However, a retired farmer, personally, need not have been in an MP relationship. In fact, this newly amended law also allows FOBID eligibility with cash rental to a"family member(s)" of the deceased farmer. The decedent's family members may also satisfy the decedent's MP requirement. In both, SUV and FOBID elections, the qualified heirs may cash rent to a family member. Family members may satisfy both the MP and at risk requirements.
Selected Indiana Code Sections for Farmland Leases:
32-2-1-1. When contracts must be in writing
[Paraphrasing this statute (known as the"Statute Against Frauds") provides that several categories of activities such as those dealing with marriage, debts, sale of lands, agreements that can not be performed in a year and more ... shall be in writing, "excepting however, leases not exceeding the term of three (3) years.
32-7-1-2 Creation of tenancy at will; month to month tenancies
Sec. 2. A tenancy at will cannot arise or be created without an express contract; and all general tenancies, except those tenancies covering lands used for agricultural purposes, in which the premises are occupied by the consent, either express or constructive, of the landlord, shall be deemed tenancies from month to month.
32-7-1-3 Notice; determination of tenancies
Sec. 3. All tenancies from year to year, may be determined by at least three (3) months' notice given to the tenant prior to the expiration of the year; and in all tenancies which, by agreement of the parties, express or implied, are from one period to another, of less than three (3) months' duration, a notice equal to the interval between such periods shall be sufficient.
32-7-1-4 Form; notice determining tenancy from year to year
Sec. 4. The following form of notice, or one substantially like it, may be used in the case of a tenancy from year to year, the date, names and description being changed to suit each particular case:
Georgetown, Floyd County, Indiana,
November 30, 1879.
To William Brown:
You are hereby notified to deliver up to me, at the expiration of the current year of the tenancy, the possession of the following described premises, viz: the south-east quarter of section six, in township two, south of range five (5), east in the county of Floyd, and State of Indiana, now held of me, by you, as tenant.
Isaac R. Keller
32-7-1-5 Rent; refusal or neglect to pay
Sec. 5. If a tenant refuses or neglects to pay rent when due, ten (10) days' notice to quit shall determine the lease, when not otherwise provided therein or agreed to pay by the parties, unless such rent be paid at the expiration of said ten (10) days.
32-7-1-7 Notice to quit; when not necessary
Sec. 7. Where the landlord agrees with the tenant to rent the premises to him for a specified period of time, or where the time for the determination of the tenancy is specified in the contract, or where a tenant at will commits waste, or in the case of a tenant at sufferance; or where, by the express terms of the contract, the rent is to be paid in advance, and the tenant has entered, and refuses or neglects to pay the rent, and in the case where the relation of landlord and tenant does not exist, no notice to quit shall be necessary.
32-7-1-8 Service of notices
Sec. 8. Notice as required in any of the preceding sections, may be served on the tenant, or if he or she cannot be found, by delivering the same to some person of proper age and discretion, residing on the premises, having first made known to such person the contents thereof; and if no such person can be found on the premises, then by affixing a copy of such notice to a conspicuous part of said premises.
NOTICE TO QUIT
*** Farmland Lease Termination ***
This is a notice to terminate the current lease (or rental) agreement between the landlord:
of (landlord's name and address)
and the tenant: of (tenant's name and address)
regarding the land (farm) known as (common name and location)
and legally described as: (Enter the legal description or attach it as an appendix.)
Sign x ( notice-maker (landlord or tenant) date
x ( added signature if multiple owner) date
**This form is believed to be consistent with IC 32-7-1-4. Effective delivery is a critical matter. The best evidence (as a legal matter) of delivery may be a "return receipt" from a sheriff's delivery. The notice-maker is urged to have a lawyer draft (or proof) his or her notice to quit and give counsel on delivery or whether notice is necessary or will be effective once delivered.