There comes a time eventually when every farm will need be sold. Often, farms are sold by the owner's choice, upon retirement or to transfer to the next generation. In other cases the sale is forced, as in the case of death, disability or financial difficulty. Whether the sale is made to the neighbour down the road or to the farmer's children, perhaps at less than fair market value, planning is necessary to ensure the sale takes place in a tax-efficient manner. A farm owner has several options.
Allocation of proceeds
There are conflicting tax consequences for the buyer and seller of farm property. It is often the case, for example, that the portion of the farm purchase price associated with the farm house and one acre of land will be exempt from tax under the principal residence exemption. The seller will want as much of the proceeds allocated to the house as possible in order to avoid taxable capital gains on this portion of the sale. The buyer, on the other hand, will prefer this amount to be lower in order to potentially increase a future tax-free gain. Additionally, in some provinces land transfer tax is applicable on real estate assets, which include the land, buildings and principal residence. Allocating more value to assets that are not subject to this tax, such as quotas and inventories, benefits the buyer.
For farm equipment, buildings and production quotas, the seller will want to minimize the allocation of the price to these assets as much as possible. The seller likely has claimed CCA/CEC (tax depreciation) as deductions on these assets over the years, reducing their depreciated tax cost. Any proceeds received over and above this depreciated tax cost, right up to the original cost of the asset, will be included as regular taxable income. The buyer, however, will want more value assigned to the quota, buildings and equipment to maximize CCA/CEC deductions against taxable income. And again, allocating more value to equipment and quota as opposed to the buildings and land may also reduce land transfer tax payable by the buyer.
A seller with any available lifetime capital gains exemption on farm property will seek to allocate more value to qualifying assets. In 2014, this exemption amounted to $800,000 per individual, and will be increased in 2015 and subsequent years as it is indexed to inflation. Land and production quotas are qualifying assets; inventory does not qualify. Sellers will seek to claim as much of this exemption as possible. Buyers obviously will prefer to allocate less value to qualifying assets in order to maximize their own exemptions in the future.
A further consideration is alternative minimum tax (AMT). Capital gains on quota sales, though they are only 50 per cent taxable, differ from regular capital gains in that they do not attract AMT, unless an election is filed to treat them as normal capital gains. As a result, it may be advantageous to a seller to allocate more value to the quota as opposed to the land asset in order to minimize AMT – particularly where it will be difficult to cover the refundable AMT in future years. AMT was discussed in more detail in the May 2014 issue of Farm Alert.
Because of the opposing interests of the buyer and seller, both parties should try to agree on the allocation and put it in writing in the purchase and sale agreement. The Canada Revenue Agency (CRA) might challenge the allocations, particularly where the buyer and seller report different amounts on their tax returns. If it is not possible to get an agreement in writing, third-party evidence can be helpful to support the reported allocation (e.g., a letter of opinion from a real estate agent).
Capital gains reserve
The possibility of capital gains reserves should be considered on every farm sale. A capital gains reserve allows a seller to delay the inclusion of a capital gain in taxable income over a maximum of five years, or 10 years in the case of a sale to the seller's children.
In order to access the capital gains reserve, the seller must take back a loan as consideration on all or part of the sale. The capital gain is then included in income as the proceeds are received. For example, in order to spread a gain over the maximum five years, the proceeds from the mortgage must be received evenly over five years.
In the May 2014 issue of Farm Alert, we noted that a capital gains reserve can help reduce the impact of AMT on a farm sale. But the reserve may also be used where the lifetime capital gains exemption is not sufficient to cover all of the capital gains on the farm sale. In these cases, the seller will use the reserve to spread the gain over several years, thus allowing more of it to be taxed at lower marginal rates and deferring when the tax is payable.
Taking back a mortgage on a farm sale involves more risk than being paid all of the proceeds up front, as the buyer might default on the loan. If there are any concerns about the buyer's ability to repay, it may be more prudent to take a pass on the capital gains reserve even if it ends up costing a bit more in tax. Additionally, it might not make sense to do the reserve if the buyer requires a loan term longer than the maximum allowed (five or 10 years) as taxes must be paid before all the proceeds on the sale are received.
Sellers who want to use the capital gains reserve on production quotas must elect to treat the gain as a normal capital gain instead of a special CEC capital gain. As a result, they might end up paying more AMT than otherwise.
Many farmers rarely or never make RRSP contributions, instead preferring to reinvest as much as possible back into their businesses. As a result, these farmers build up significant unused contribution limits that can be used to defer tax on a farm sale.
Where there is adequate contribution room, a seller might make a lump sum RRSP contribution to offset taxable income otherwise included in the year of the farm sale. Then, in future years the RRSP contribution may be systematically withdrawn in a way to minimize taxes owing. The seller would not necessarily have to wait until retirement to withdraw the RRSP, depending on their other sources of income.
These are just a few of the planning strategies available on a farm sale. As always, the complex nature of this subject and the variety of situations cannot be covered exhaustively in this article. Contact your Collins Barrow advisor for assistance on any farm sale transaction to ensure that it is handled properly.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.