Canada: The Capital Gains Exemption: Beware Of In-Law Quirks

In Canada, qualified farmland can be transferred from one generation to the next for any dollar amount between cost and fair market value (FMV) at the time of the transfer. Any capital gain triggered by the transfer is covered by the capital gains exemption (up to $1,000,000 for farmland), assuming the land is qualified farm property.

For land to be considered qualified farm property, either the current owner or a past owner must "qualify" the land. Specific rules apply, but generally, qualifying the land means:

  • The land was used principally (more than 50%) in farming. (Land rent income is not considered farm income.)
  • The person who qualified the land had gross farm receipts greater than all other sources of income for a minimum of two years during the time they owned the land.
  • The land was owned by a Canadian citizen.

Once the land is qualified, it remains qualified for up to four generations until it is sold to a third party who is not considered a family member. Thus, a third generation, non-farming family member could qualify for the capital gains exemption (CGE). (For more information on how to qualify farm property and who can do this, please refer to the Collins Barrow Farm Alert from December 2016.)

Notwithstanding the above, the CGE does not apply for farmland in some particular cases, such as the death of the farm owner's spouse. Consider this example:

Farmer A owned 500 acres of farmland and farmed it his entire life. The land was never rented, and his gross farm receipts were greater than all other sources of income for at least two years while he owned the land. Once farmer A was ready to retire, he transferred the land to his son for a value that maximized his CGE. The son actively farmed the land for 10 years and then rented the land to a neighbour for 15 years. The land remained qualified since the father, farmer A, qualified it during the time he owned it.

Farmer A's son was married with two children. Unfortunately, the son passed away early in life, leaving all assets to his wife. His wife continued to rent the farmland to the neighbour, as she had no interest in farming. A few years after her husband passed away, the wife sold the farmland to the neighbour.

In this case, the wife does not qualify for the CGE. After her husband dies, she is no longer considered to be related to farmer A. The Canada Revenue Agency holds that the "in-law" relationship ceases to exist upon the death of farmer A's son, the wife's husband. Upon the son's death, the wife ceases to be "connected by marriage" or "connected by blood relationship" to farmer A and any siblings of her late husband.

In contrast, if the husband left the farmland to his children, they would be eligible to claim the CGE when they sell to a third party or transfer to the next generation, since their grandfather qualified the land.

In order for the wife to be eligible to claim the CGE on any applicable gain in this case, she must qualify the land on her own based on the rules listed above. She may do so with a properly structured sharecropping agreement if she is not able to farm the land herself. Her children may also qualify the farmland for her if they follow the rules above.

Estates can create similar difficulties with the farmland CGE. Consider another example: farmer A plans to leave the farmland to his son in his will. He adds a provision in the will that provides for the land to transfer to his daughter-in-law in the event that his son pre-deceases him.

Again, the daughter-in-law (wife) is not considered a family member. Consequently, the farm must be transferred at FMV only; no provision exists to transfer it at any value between cost and FMV. In addition, the wife may not claim the CGE when she disposes of the land since she is no longer related to farmer A after her husband passed away. In this case, farmer A should instead consider leaving the farm property to his grandchildren.

Farmers should be aware of – and plan for – this quirk in the capital gains exemption rules. With the high value of farmland today, there are often significant gains when farmland is sold or transferred to the next generation. To discover after the land is disposed of that it is no longer considered qualified farm property can be quite a shock and can create significant tax consequences. Contact your Collins Barrow advisor for more guidance.

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.

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