Use Capital Gains Deduction Sooner Rather Than Later | FBC, Canada's Farm & Small Business Tax Specialist

Use Capital Gains Deduction Sooner Rather Than Later

If long-term tax deferral is a family priority, consider raising the adjusted cost base of your farming assets before control of the business passes along to the kids.

Almost 80% of family businesses in Canada face change of ownership, or at least leadership, within the next decade due to the aging of the baby boomer generation.

This equates to almost $3 trillion in business assets that could change hands. Since most farm businesses in Canada are family-owned and operated, they will mirror this pattern.

Planning for the day when you must dispose of your farm assets provides more flexibility and opportunity to minimize taxes. But you can do more than just plan what's going to happen when the day for transfer or sale actually arrives.

You can act now to increase or step up the adjusted cost base (ACB) of your land for any future sale or deemed disposition on death. This is done by locking in or "crystallizing" the $800,000 enhanced capital gains deduction.

The capital gains deduction is available on qualified farm property (QFP) and qualified small business corporation shares. Note the word "qualified". It's very important to understand exactly what that means in the context of crystallization strategy.

Qualified Farm Property

QFP is certain real property such as land and buildings used in carrying on a farming business in Canada by an individual; a spouse, child or parent of the individual; a family farm corporation/partnership of the individual, spouse, child or parent; or beneficiaries of certain personal trusts.

The definition of QFP also covers shares in a family farm corporation, interest in a family farm partnership, and certain eligible capital property such as quota.

An abbreviation checklist
ACB adjusted cost base
AMT alternative minimum tax
CGD capital gains deduction
FMV fair market value
GST goods and services tax
QFP qualified farm property

Machinery and equipment are not considered QFP for the purpose of the capital gains deduction. Several usage and ownership tests must also be met in determining whether assets come within the definition of QFP.

You can crystallize capital gain in several ways without losing family control of land. These alternatives usually include selling the property at fair market value (FMV) to a spouse, child (or children), corporation, partnership, or trust.

The transaction must be structured so that the actual sale price is secured by cash or debt. The price can be any value between the FMV and ACB. Generally this amount is based on the accrued capital gains on the property and the amount of capital gains deduction still available to the seller.

If QFP is gifted instead of sold, it rolls over, in most cases, at the ACB without triggering capital gains. This could result in permanent loss of the older generation's capital gains deduction.

Debt owned by the buyer can be in the form of a promissory note and/or a mortgage on the property. The promissory note can bear interest or not, have repayment terms or be due on demand, and be secured by a general security agreement.

Promissory notes and/or mortgages are frequently used since purchasers such as a spouse or child may not have the resources to pay for the property. Any balance remaining on the debt on the death of the vendor, such as a parent or spouse, may be forgiven without adverse tax consequences if this is done through a will.

Debt forgiveness through a will offers a significant advantage over straight-out gifts in that it leaves some control in the hands of the parent or spouse who is transferring the property.

It also avoids reducing the ACB for the recipient of the gift by the amount of debt forgiven. Tax law requires that the ACB be reduced by the amount of the gift. If the promissory note covering the ACB of the property is $500,000 and $250,000 is paid down with the balance gifted, the ACB is no longer $500,000 but rather $250,000.

Another significant benefit to structuring the transaction as a sale is that the purchaser (spouse or child) gets immediate access to his or her own capital gains deduction to shelter future capital gains from tax.

A transfer of QFP to a corporation owned by a farmer can be structured so that it results in a sale at FMV to crystallize any accrued capital gains.

Qualifying farming assets can also be transferred to a partnership formed by a husband and wife or parent and child at a price in excess of the ACB. This not only triggers a capital gain, but also provides the opportunity for income splitting under the partnership agreement.

Transfer of qualified farm assets to most trusts also triggers a capital gain where the Income Tax Act does not permit a rollover to the trust.

Here's an example of how crystallization works:

A farmer and his wife jointly own farmland that is QFP. They bought it for $100,000 in 1980. Now it's worth $1.6 million, giving them a $1.5 million capital gain. They want to pass the farm operation to their children someday, but expect they'll need funds for retirement.

They incorporate a company structured so that each spouse receives 100 shares. They sell the farmland to the corporation for $1.6 million and receive payment (in the form of a first mortgage on the property) from the corporation in the same amount.

Each then reports a $750,000 capital gain that is sheltered from tax by their $750,000 capital gains deductions. Then, as funds become available, they can draw up to $800,000 ($1.6 million in total) from the company tax-free. The ACB of the farmland inside the corporation is $1.6 million. That's the base from which the children calculate any future capital gain.

At retirement, the parents can transfer their qualifying shares in the corporation to the children with little or no tax impact under the available rollover provisions for shares in a family farm corporation.

Some additional considerations:

  • Always consider the impact of GST/HST on any proposed transaction. In the above example, it would be best to register the corporation for GST/HST purposes before proceeding with the transfer of property.
  • Alternative Minimum Tax (AMT) can also be triggered when crystallizing capital gains. You get a 7-year recoverable carry-forward for AMT, but might need ready cash up front.
  • Crystallizing a capital gain to take advantage of the capital gains deduction will increase net income (calculated before the deduction) on a one-time basis by the amount of the capital gain. This could disqualify you for government payments that depend on net income means tests, such as the child tax benefit, guaranteed income supplement, goods and services tax credit and old age security.
  • Recapture of capital cost allowance also can be triggered on transferred depreciable assets such as buildings located on farmland or eligible capital property.
"As long as you’re going to be thinking anyway, think big." — Donald Trump