Farmers and small business owners have a lifetime capital gains exemption of $800,000, which will save you tax money on the sale of farmland and other qualified property.
In 2013, the federal budget increased the lifetime capital gains exemption (LCGE) to $800,000 from $750,000 for capital gains on the sale of qualified farm property or qualified small business corporation shares effective for transactions occurring after December 31, 2013.
This is good news for farmers, fishers and incorporated small business owners who plan to sell their business to third parties or pass it on to family members.
Because the inclusion rate for capital gains and losses is 50%, your lifetime capital gains deduction limit is $400,000 (1/2 of $800,000). In other words, because you only pay income tax on half of your capital gains, the $800,000 exemption actually reduces your taxable income on the sale by $400,000.
Whether you plan to exit from your business soon or down the road, ensuring you can maximize your LCGE to minimize your tax costs is a complex matter that takes proper planning and advice from a tax expert.
Qualified Farm Property
First, you’ll want to be clear that your property actually qualifies for the LCGE.
To meet the definition of qualified farm property, your property must be used in the business of farming by either by you; your spouse/common-law-partner, child or parent; or by a family farm partnership or corporation. Qualified farm property includes your farmland and buildings, shares in a family farm corporation or an interest in a family farm partnership, and quota.
In addition, the government uses 2 other tests – the 5-year usage test and the 2-year gross revenue test – to determine whether your land or quota is qualified farm property.
The 5-Year Test
If you bought or entered into an agreement to buy your property before June 18, 1987, it will be considered qualified farm property if either you or the other individuals/entities mentioned above used the property principally in the business of farming in Canada either in the year you disposed of it or for at least 5 years during which any of you owned it.
The 2-Year Test
Canada Revenue Agency (CRA) also will consider your property to be used in a Canadian farming business if you or any of the persons mentioned above owned the property throughout at least 24 months prior to the sale. In addition, during at least 2 years while the property was so owned, that person must have been actively engaged in farming on a regular and ongoing basis and his/her gross income from the farm business was larger than his/her income from all other sources.
Land Rental Could Negate LCGE
While planning for the eventual disposal of your qualified farm property, you also need to keep in mind how you are using the land or quota prior to the sale.
For example, rental of your land could negate your capital gains exemption and/or your ability to execute a tax-deferred farm rollover to your children either during your life or at death.
CRA does not generally consider owners who rent their land on a cash or share-crop basis to be using their land in the business of farming. CRA considers a landlord’s receipt of a share of the crop to be rental income and not income from farming.
Fortunately, you can get around this by renting out your land under the right type of business agreement – either a custom work or joint venture agreement.
As long as you maintain control over all of the key management decisions, such as which fields to plant, the crops to seed, and the times for spraying and harvesting, CRA should still consider you to be in the business of farming even if you hire someone to work the farm for a flat fee or hire a custom operator to carry out many of the farm’s operations.
Requires Proper Tax Planning
There are even more complex rules that apply in determining whether the LCGE is available on the sale of shares in a family farm corporation or an interest in a family farm partnership. Such property that is currently offside of the rules can often be put onside with advance tax planning.
If you are planning to transfer the farm to your spouse or children, you may be able to set things up so you and your family members all are able to access your individual lifetime capital gains exemptions. For example, if your spouse has an ownership interest in your farm property — an interest he/she purchased with his/her own funds — capital gains on the property will accrue to both of you. Then, when you dispose of the farm, you both might be able to claim your individual $800,000 LCGE.
You also could transfer ownership of your farm to your children, either at death or during your lifetime, in such a way that you and they could all realize your individual LCGEs. But you will need to account for both the farm rollover rules as well as the rules for the capital gains exemptions, so you definitely need an expert’s input.
You’ll also want to talk with your accountant or tax advisor about potential drawbacks to claiming your capital gains exemption.
For example, a taxable capital gain, even one against which the exemption can be applied, will still increase your net income for tax purposes.
If the gain pushes your income over the threshold for receipt of benefits like OAS, employment insurance and other benefits, your payments could be clawed back. The capital gain also could trigger an alternative minimum tax (AMT) liability on your tax return, which could cause cash flow problems during the year you need to pay the tax.
The 2007 federal budget had increased the LCGE to $750,000 from $500,000. When it comes to doing the actual calculations, for tax years after 2008, you will calculate your LCGE limit following the usual calculation. But if you are realizing capital gains from 2007, you should use the following 3-step process for calculating your capital gains deduction:
- Calculate your capital gains deduction for 2007 as if the limit remained at $250,000 (half of $500,000).
- Determine an additional amount (not over $125,000) that is the increase in the cumulative gains limit at the end of 2007 attributable to the net taxable capital gains from dispositions made after March 18, 2007, to the extent it exceeds the amount in step 1.
- Add the amounts from steps 1 and 2.
Needless to say, the capital gains exemption is a very complex tax matter. We strongly recommend you seek the advice of your tax specialist long before you wish to dispose of your farm property. Then you’ll be able to plan for making the most of your LCGE — and the LCGEs of your family members.
If you would like a free consultation to find out how FBC can help you with your small business tax needs, call 1-800-265-1002, or email today.