A couple we’ll call Chuck, 68, and Liz, 66, farm 1,000 acres in south-central Manitoba. Their all-grain operation is profitable, but they want out. Their children, two middle-aged daughters, are not interested in farming. That leaves the sale of the farm as the best and only way for the couple to quit the business and get cash for their retirement.
Chuck and Liz asked Colin Sabourin, a farm transition specialist with Winnipeg Financial Planning, to help devise an exit strategy. The task is significant in terms of the couple’s $6.435 million net worth, 92 per cent of which is farm assets, and their own preference for avoiding the conventional risks of financial assets like stocks and bonds.
It’s useful to dissect farm assets to determine value and a method of disposal, Sabourin explains. He notes that the farm equipment and buildings have a current value of $600,000 and $400,000, respectively, for a total of $1,000,000. Their combined, un-depreciated capital cost is $657,000, leaving $343,000 as a taxable gain. The couple also have $300,000 of unsold inventory that will be taxable when sold.
$1 million lifetime capital gains exemption
The couple’s farmland is worth $6,600,000. They paid $1,250,000 for it, so their nominal capital gain is $5,350,000. The farm is jointly owned, so the couple can split the capital gain and each partner thus has a $2,675,000 gain. Only half the gain is taxable, so each will have to report a gain of $1,337,500 for tax. Each can take a $1 million lifetime capital gains exemption, this can reduce net income by $500,000 each.
In addition to the business or farm income, they receive Canada Pension Plan retirement pension in the amounts of $6,000 for Chuck and $5,150 for Liz. Each gets Old Age Security (OAS) pensions at $7,380 per year in 2021.
If Chuck and Liz sell all of their farm assets this year, they would each have taxable incomes of approximately $1,161,043 and $1,160,193, respectively, and tax bills of $569,846 and $569,419. Those bills add up to $1,139,265. They would have
$6,760,735 after tax. After paying off debts, they would have $4,775,230 for their retirement. Each would lose OAS in the year of the asset sale, for both would be far over the maximum clawback threshold for OAS of $129,075, when all OAS paid would be gone.
The clawback takes 15 cents of each dollar in the interval between the trigger point, $79,845 this year, and the point at which all OAS is taken back at $129,075 of total income. Added to ordinary income tax, the marginal rate for the combined taxes can be in a range of 50 per cent to 63 per cent. Once all OAS is taken back, the total rate, which is then just regular income tax, drops by 15 per cent.
Chuck and Liz can reduce their tax bills by using Registered Retirement Savings Plans (RRSPs). Chuck has $159,000 of room and Liz $87,000 of room. If each uses up all of that room, they would reduce their total tax bill by $123,894, Sabourin estimates. In subsequent years with much lower incomes, they could tap the RRSPs. In this case, they would save tax at about 50.4 per cent today and pay only 27.75 per cent on future. That’s about a 23 per cent tax savings. Moreover, their OAS could be restored in future years, Sabourin notes.
Qualified farmland exemption
There are two alternative strategies to cut taxes. The first is to use the qualified farmland exemption of $1 million per owner and the second is to shift some assets to a farm corporation in the year of sale.
In the first case, if Chuck and Liz gift the farmland to their daughters, it would be the daughters who would take on the eventual tax obligation when they sell. However, if the daughters hold the land for at least three years and then sell, they can use their own lifetime capital gains exemption.
This strategy would enable Chuck and Liz to shelter $4 million of the estimated $5,350,000 capital gain, twice the $2 million of our first strategy explained above. The parents would walk away with an additional $500,000 after tax.
Incorporate in final year
The final way to shelter farm gains is to incorporate in their final year of farming. At present, all income is attributable to Chuck and Liz. If they incorporate, they can put inventory, equipment and buildings into the corporation and pay only a nine per cent tax on the first $500,000 of income followed by 27 per cent on income over the threshold.
The present taxable income of their equipment, buildings and inventory is $643,000. Selling this personally would incur a $324,072 tax. But via the corporate structure, the bill would be only $83,590. Money would still be in the corporation, but it would be possible to with- draw it slowly when they are in lower brackets and pay only 27.5 per cent on the withdrawals.
The balance is clear. If Chuck and Liz do no tax planning, they will have $4,775,231 from their farm sale. If they do strategic planning, they can save a few hundred thousand in taxes.
What they do with their savings is the next issue. Currently, Chuck and Liz have $145,000 in their RRSPs and $40,000 in Tax-Free Savings Accounts (TFSAs). Not only have they not taken full advantage of these tax shelters, they have invested what is in them in low interest GICs and left a great deal of cash in savings accounts that pay one per cent or so before inflation and minus one per cent to minus two per cent after inflation, Sabourin estimates.
Fixed income investing rewards the patient, but when interest rates lag inflation, a dollar today can become a dime tomorrow. Accordingly, a program of investment in large cap stocks that pay dividends of three to five per cent, as chartered bank shares do, perhaps a low fee exchange traded fund focused on Canadian and/or American shares with annual costs of small fractions of one per cent (compared to an aver- age cost of 2.5 per cent for Canadian mutual funds), or balanced funds with some bonds for backup when stocks sag would give the money they harvest from selling the farm a chance to keep up with inflation.
The results of a program of buy and hold investing in stocks with solid and growing dividends can be estimated from the easy-to-use rule of 72s. Divide 72 by a rate of growth or interest and you get the number of years it takes a sum of money to double. For example, for a four per cent rate of return including dividends, 72 divided by four is 18 years. That would put Chuck and Liz at ages 86 and 84. For stocks with a five per cent return rate, money would double in 14 years — Chuck and Liz would be 82 and 80.
Picking stocks or mutual funds or exchange traded index funds takes study and advice. In retirement, Chuck and Liz would have time to study capital markets and generate returns commensurate with the time and dedication they put into farming.
They could minimize taxes by using their very large TFSA space so that they might never have to pay tax again on money already taxed before going into the TFSA. Their time for use of RRSPs will end soon, so the TFSA is the best simple shelter available.
“What we have suggested is a clean break with farming,” Sabourin explains. “The couple would have a substantial amount of cash to live on or to invest. That’s a big responsibility for which they might take advice or devote time for study. I wish them well.”