CHICAGO, Feb 15 (Reuters) - Farmland values in the U.S. Plains states jumped more than 20 percent in the fourth quarter from a year earlier as farms sold at record-high prices, with the biggest jump seen in irrigated land given the worst drought in 50 years to hit the world's top food producer, the Kansas City Federal Reserve bank said.

This was the seventh consecutive quarter irrigated and non-irrigated cropland values posted year-over-year gains of more than 20 percent as record crop prices kept demand hot for farmland, according to a quarterly survey of bankers by the Kansas City Fed released on Friday.

"What really stuck out in the survey was the difference between irrigated and non-irrigated cropland values...irrigated land is a way to protect from the possibility of these droughts," said Nathan Kauffman, a KC fed economist and one of the authors of the survey.

"Persistent drought sparked a rush in irrigated farmland sales during the fourth quarter of 2012. Stronger sales vaulted irrigated cropland values in the District 30 percent above year-ago levels, with a 13 percent jump in the fourth quarter alone," the Fed said of its survey, which draws on comments from 232 district bankers.

Non-irrigated cropland and ranchland posted strong annual gains of between 20 and 25 percent.

The KC Fed district stretches across major wheat, corn and cattle states of Colorado, Kansas, Nebraska, Oklahoma and Wyoming along with parts of New Mexico and Missouri.

U.S. Plains Farmland Values

Farmland values are closely tracked by government economists as a gauge of the U.S. economy and health of the banking system. In recent years both crop prices and farmland prices have set records as the burgeoning biofuels industry and record food exports spotlighted the value of hard assets.

In turn, farm income has also set records. But skyrocketing land values have stirred banker fears about the possibility of a ruinous farmland bubble like the one seen in the 1980s U.S. farm crisis, when over-leveraged farmers lost their land when interest rates jumped.

"Farm prices are high, but so are commodity prices and interest rates are very low. Those are the two biggest determinants of what farm ground should sell for," said Phil Burns, chief executive of F&M Bank in West Point, Nebraska. "The question becomes how sustainable are either or both looking longer term? In the short term everything looks fine."

The Kansas City district survey comes after fourth quarter surveys earlier this week from the St Louis and Chicago Fed banks. The latter two surveys covered the northern Corn Belt and central Delta states, with both reporting similar results - strong farm income aided by crop insurance and strong farm spending for land and equipment, partly due to year-end doubts about higher taxes in 2013.

Farmers remain the predominate land buyers, accounting for three-fourth of the sales in the Plains in the fourth quarter. Bankers said farmers used more cash to finance purchases compared to a year ago. Nonfarmers continued to buy land for investment purposes.

"Almost all recent auctions were sold to the largest farmers in the area wanting to get bigger. The buyers are strong and most are cash sales," said one banker from northwest Missouri.

Cash rental rates also surged in the quarter, with irrigated cropland up 20 percent and non-irrigated rising more than 14 percent.

Farm Income Strong Despite Drought

Farm incomes rebounded in the quarter despite expectations that drought would hurt profits, the KC Fed said.

"Crop incomes remained high, as farm operations with irrigated cropland had less yield loss and sold crops at high prices, while many farm operations without irrigation received crop insurance payments, mitigating losses," the bank said.

Following the autumn harvest crop prices eased back as export demand weakened and ethanol production slowed, providing some relief to livestock producers through lower feed costs. Significantly, cattle and hogs firmed in the quarter improving profits in the livestock sector toward the end of 2012. The district contains the top cattle feedlot states, with the exception of Texas.

Higher farm incomes boosted capital spending and led to improved agricultural lending conditions, although overall loan demand remained low with many grain farmers flush with cash. Loan repayment rates increased at a pace on par with a year ago while interest rates for operating and real estate loans edged lower, the bank survey said.

"Although fourth-quarter incomes were better than expected, bankers expressed concerns that drought could affect some areas further in coming months. Farm incomes were expected to drop in Kansas and Oklahoma, as pasture conditions generally remained poor due to ongoing drought. But strong farm incomes were expected to continue in areas with sufficient water availability," the Fed said.

"Water scarcity led to differing farm incomes and farmland-value gains by state," the bank added.

(Reporting by Christine Stebbins)