Introduction
One of the most important tax benefits available to you is the
ability to avoid tax on up to $500,000 of capital gains arising on
the sale of certain farm properties. This is a cumulative exemption
that applies over your lifetime in respect of sales after 1984.
Because this is a generous tax exemption, there are complicated rules in the Income Tax Act which are intended to ensure the benefit is available only to persons who meet all the requirements. As a result of this complexity, you need to ensure that you receive appropriate advice well before entering into any transaction that is designed to take advantage of the exemption.
It is important to note the exemption is available only in respect of capital gains. Therefore, income arising from the sale of your livestock is not eligible; nor is recaptured depreciation on your buildings and quota.
The $500,000 limit refers to the gross gain and not the taxable portion. As a result of the 2000 federal budget in February 2000 and the mini-budget in October 2000, the government is proposing that the taxable portion of capital gains realized after October 17, 2000 be reduced to one-half. If this change is enacted, the effect of the deduction (where there is a one-half income inclusion) will be to exempt from tax up to $250,000 of taxable capital gains.
Remember the deduction is not available to a company. If you have incorporated your farm the only method by which you can benefit from the deduction is to sell the shares of your company.
Also remember the deduction applies to each individual. If you and your spouse own the farm jointly, each of you may be entitled to the $500,000 deduction.
Property Eligible for the Deduction
The farming assets eligible for the $500,000 deduction are,
generally speaking, restricted to those owned by an individual and a
partnership, an interest in which qualifies as an interest in a
family farm partnership (see Glossary).
The types of property that are eligible are generally restricted to the following:
1. Land and buildings used in a farming business
by
>the individual, his spouse, his parent or any of his children;
>a company, a share of the capital stock of which is a
"share of the capital stock of a family farm corporation"
(see Glossary) of the individual, his spouse or any of his children;
or by
>a partnership, an interest in which is an "interest in a
family farm partnership" (see Glossary) of the individual, his
spouse or any of his children.
2. A "share of the capital stock of a family farm
corporation" (see Glossary);
3. An "interest in a family farm partnership" (see
Glossary); and
4. Quotas used in a farming business.
Note this listing excludes machinery and livestock.
Land and buildings, acquired before June 18, 1987
will be treated as farming property provided it was used principally
(ie. chiefly) in farming by an individual, partnership, or
corporation mentioned in paragraphs 1 - 3 above:
>in the year the property was sold, or
>in at least five years during which the property was owned by
the farmer, his spouse, his parent or his child.
Where the land, buildings or quota was acquired (or is deemed to be acquired) after June 17, 1987, the rules are tougher to meet. First, there is a two-year holding requirement; second, there is a two year "use" test; and finally there is a requirement that during that period, the individual, his spouse, child or parent, as the case may be, are actively engaged in the business of farming on a regular and continuous basis. These additional requirements will not usually be a problem for the full-time farmer. However, the fact they exist makes it even more important to check on the status of your farm property before you sell it.
When the government eliminated the basic ($100,000) capital gains deduction, it gave individuals an opportunity to file an election with their 1994 income tax return in order to take advantage of the deduction they had not used. Essentially, the election had the effect of deeming individuals to dispose of, and then re-acquire, properties (such as land) that were specified in the election.
The reason for mentioning this is that if you specified your farm land in a capital gains election filed with your 1994 return, your property will now be looked upon as having been sold and then re-acquired in 1994. As a result, the post-June 17, 1987 capital gains deduction rules will apply when you sell the property even though you may have purchased it before June 18, 1987.
It appears that in some circumstances, the sale of timber by an individual from land that has been used in the business of farming may qualify for the deduction, even though the land itself is not sold. Accordingly, if you are proposing to remove trees from land that has been farmed, you should obtain advice before the transaction occurs.
It is important to note there are differences between the nature of the shares of a company which are eligible for the $500,000 capital gains deduction and those which are eligible for the "rollover" from parent to child. The same is true for an interest in a farm partnership. The differences are not likely to affect too many real-life situations but conceivably, shares of a farm company (or an interest in a partnership) could be eligible for the deduction but not the "rollover".
The capital gains deduction is not affected by the claiming of an exemption in respect of the gain on the sale of your principal residence.
What About Rental Property?
Depending on the circumstances, land and buildings which are
rented to your child or spouse for use in a farming business may
qualify for the exemption. This can also be true for land rented to
a company or partnership.
Even where your land is currently rented to a person outside of the family, the previous use of the property by you, your spouse or a child may enable you to make use of the exemption.
The Deduction May be Multiplied
In certain circumstances, it may be possible to make greater use
of the family's capital gains deduction by gifting an interest in
certain farm property to an adult child (or children) resident in
Canada and for the whole family to sell their respective interests
at a later time. Clearly, this type of planning should be considered
well before a sales transaction is entered into. Moreover, there are
a number of issues that would have to be considered before taking
this step, not the least of which is the general anti-avoidance rule
in the Income Tax Act.
Where property is registered in the name of only one spouse, it is possible on occasion to use the principles of constructive or resulting trusts to support the view that both spouses have an interest in the property. If this can be supported, both spouses might be entitled to the capital gains deduction, instead of one. If your farm is registered in your name alone but both you and your spouse have contributed substantially to the purchase of the property, or you have always considered the farm to be jointly owned, you may wish to discuss this matter with your lawyer.
What Happens if You Claim a Reserve in Respect
of the Unpaid Sales Price of Your Farm
If you sell capital property in exchange for debt, you may be
entitled to claim a reserve for income tax purposes in respect of
the unpaid proceeds. If you are able to claim a reserve, it would
have the effect of spreading your capital gain over a number of
years. The length of the period over which the reserve is available
depends on the nature of the property, the terms of the sale and
whether or not the purchaser is your child.
If the property being sold is one for which the $500,000 deduction is available (eg. land, buildings, shares of a family farm company or an interest in a family farm partnership) the capital gains deduction can be claimed in each year in which a portion of the capital gain is included in income.
What Happens if Your Partnership is Not a
Family Farm Partnership?
As noted previously, the $500,000 deduction is available in
respect of qualifying land and buildings owned by a partnership, an
interest in which qualifies as a family farm partnership (see
Glossary). If the partnership does not qualify as a family farm
partnership (perhaps because substantially all of its property is
not used in the business of farming in Canada), then the taxable
capital gain on the sale of any land, buildings or quota owned by
the partnership, or the sale of the partnership interest itself, is
not eligible for the $500,000 deduction. This could make a
tremendous difference in the tax that would be payable, so you need
to have your accountant review the status of your partnership before
you sell. If your partnership doesn't qualify, your accountant
should be asked to identify the steps necessary to remedy the
situation.
Can You Always Claim the Deduction?
You need to be aware there is a rule in the Income Tax Act that
restricts your ability to claim the deduction if you have deducted
"investment expenses" (see Glossary) from your income in
1988 and subsequent taxation years or if you have deducted capital
losses from your other income. This rule will not likely affect too
many farmers but could affect you, for example, if you have borrowed
to acquire shares in a family company. The interest on your
borrowings will be treated as an "investment expense" and
unless on a cumulative basis, this expense is offset by
"investment income" (see Glossary) a portion of your
future taxable capital gains will be subject to tax.
Your accountant will know whether this will be a problem for you and, if it is, whether it can be dealt with prior to the sale. This is another matter to be checked before you commit yourself to a deal.
Don't Forget the Refundable Minimum Tax
In response to political pressure from people who were upset
about certain individuals receiving substantial income without
paying "a fair tax", the government introduced a
"refundable alternative minimum tax". This tax obliges
many taxpayers to make two tax calculations each year. The
additional one was intended to apply primarily to individuals who
avoid paying tax by investing in tax shelters of one kind or
another. However, the rules are such that the calculation is also
required if you realize a significant capital gain on the sale of
your farm.
In most situations involving the transfer of a farm from a parent to a child, it should be possible to alleviate the effect of the minimum tax, if the proper planning is done before the transaction is carried out. Where the farm is being sold to a person outside the family, the scope for planning may not be as significant.
Fortunately, the refundable minimum tax rules will not apply to a taxable capital gain on the sale of quota, nor will they apply to any gains arising from the deemed disposition on death.
How Can I Get the Minimum Tax Back?
As indicated by its name, the minimum tax is intended to ensure
that all Canadian individuals pay at least a minimum amount of tax.
Individuals with substantial incomes must calculate their taxes
under the regular method and under the alternative method and pay
whichever is the higher. If the alternative tax is higher, the
amount of the excess can be carried forward and deducted from the
regular tax liability in the next seven years. The carry-over of
these additional taxes cannot reduce a taxpayer's liability to an
amount that is below his minimum tax for the year.
Because of this seven-year carry-forward, any minimum tax that is paid on the sale of the farm will often be recovered in full in the years following the sale. Any minimum tax that is not recovered before death is no longer recoverable.
Don't Forget the Other Implications of
Realizing Capital Gains
If you realize a capital gain on the sale of your farm, there
can be other implications as well. These include the following:
>there may be a "clawback" of your old age security
pension
>there may be an impact on your income supplements or child tax
credits
Some Questions and Answers
1. We are considering the transfer of our farm to our son in the
next two to four years and we will want to take advantage of the
capital gains deduction. We are concerned, however, that the
deduction might be taken away before we can use it. Do you have any
advice?
This is a concern to many farmers, as they near retirement. The
capital gains deduction is an extremely valuable tax concession; one
wonders whether it will remain in the Income Tax Act over the long
term particularly when:
a) the deduction contributes significantly to the ever-increasing
complexity of the Income Tax Act;
b) the deduction has probably not contributed significantly to new
investment in Canada (which was the primary objective) but has, on
the other hand, enabled persons who have already accumulated
substantial gains to realize them without paying tax; and
c) a committee, commissioned by the federal government to review our
income tax system, has recently recommended that the deduction be
eliminated.
Clearly, we can only guess as to whether these and other reasons might cause our government to remove the deduction and, if it does, whether it will be done so that it applies only to gains that accrue in the future or to all gains that are realized after the change is made.
Now that the taxable portion of capital gains is to be reduced to 50%, the refundable alternative minimum tax is more of an issue. If you take steps to lock in your full $500,000 deduction, the refundable tax might be $40,000 or more. Given that the benefit of the capital gains deduction is now reduced to approximately $125,000 (because of the reduced taxable portion), it is more difficult to justify the triggering of a capital gain that would expose you to this tax (unless, of course, you sell your property and have the cash to pay the tax).
Nevertheless, if the availability of the deduction
is vital to your estate plan, or you are concerned that your
property may cease to be eligible for the deduction, you may wish to
look at whether you can reorganize your farm so that:
a) you crystalize at least some of your accrued capital gains now
and take advantage of your capital gains deduction and
b) you facilitate the ultimate transfer of your farm to your child.
The way in which you might use some or all of your
deduction will depend on the manner in which your farm is organized.
The possibilities include the following:
Sale to Partnership
If, for instance, you operate as a sole proprietor, you might
consider transferring your assets to a partnership in which you and
your spouse are the partners. You could arrange for your son to
become a partner (without necessarily acquiring any of the existing
value), or defer this to a later time.
Sale to Spouse
Another option might be to transfer certain property to your
spouse and elect out of the "rollover" rule that normally
applies.
Use a Company
You could also consider the transfer of some or all of your
assets to a company. If you already have a company, you might
discuss with your accountant the possibility of reorganizing the
capital so that you crystalize some of the accrued gain on your
shares and take advantage of your deduction.
2. I inherited our farm from my husband and,
since that time, I have rented it to my son. Would the capital gains
deduction apply if I were to sell it?
The answer to this question depends to some extent on whether
you inherited the farm after June 17, 1987. If you did, then it is
likely you will be eligible for the deduction provided:
a) you and/or your husband have owned the property for more than two
years; and
b) for a period of at least two years, prior to your husband's
death, his gross farming income exceeded his net income from all
other sources and, during this period, he was actively engaged in
the business on a regular and continuous basis; or
c) for a period of at least two years, while your son rented the
farm, his gross farming income exceeded his net income from all
other sources and, during this period, he was actively engaged in
the business on a regular and continuous basis.
If you inherited the farm before June 18, 1987,
you will likely be eligible for the deduction if:
a) the property is farmed by your son in the year of sale, or
b) the property has been farmed for at least five years in the past
by your son or your husband.
Because this is a very complex matter you should always have an experienced adviser review all the facts and give you a written opinion. If you inherited the farm before June 18, 1987, the adviser may want to examine your 1994 personal income tax return to determine whether you filed a capital gains deduction election in that year. If you did, the status of your land may be affected.
3. My wife and I own the farm land jointly but
I have always reported the farm activity on my return. Can we both
claim the capital gains deduction if we were to sell the farm?
On the surface at least, the answer to this question is probably
yes. If the land has been used in farming to the extent required by
the Income Tax Act (and this depends on the date it was acquired),
the fact that your wife owns a half interest and has not been
involved in the business (except perhaps as an employee) does not
prevent her from claiming the deduction.
An issue in this situation will be whether you have, in effect, "transferred" or gifted a half-interest in the land to your wife after 1971. If you have, it is possible your wife's share of the capital gain would be "attributed" to you and you would not be able to take advantage of her deduction.
Much will depend on when the property was
purchased, whether the purchase was made from funds that both of you
had accumulated and the extent to which you have repaid the purchase
debt from funds generated by the farm.
Because this is a complicated area you should make sure you discuss
it with your accountant.
4. Does the $500,000 capital gains deduction
apply to my machinery and equipment?
Unfortunately no. Remember also that the deduction cannot be
used to offset recaptured depreciation.
5. Our farm land has always been registered in my husband's name alone, and he has always reported all of the farm income. However, we have always considered this to be a family business. I have been heavily involved in many aspects of it and a portion of the farm assets was acquired with my money. Can both of us benefit from the capital gains deduction?
This is not entirely out of the question - much depends on all of the background circumstances. At the present time, your husband is the legal owner of the land but it's possible that both you and your husband are the beneficial owners (see Chapter 2 for a brief discussion on this matter). Keep in mind that it is the beneficial owners of property who must account for the capital gains on the sale of the property and, depending on the circumstances, have the opportunity of using the capital gains deduction. If you are planning to sell the farm and the taxable capital gain will exceed your husband's capital gains deduction, it might be worthwhile meeting with a lawyer who is experienced in these matters. In preparing for this meeting, write out a very detailed history of your farm, including the dates on which the major assets were acquired, and the extent to which funds have been invested in the farm by each of owners.
