David, a name we’re giving to a tree farmer in eastern Ontario, is 83. His wife passed away some years back. He converted a 47-acre former hay and horse farm to trees. Now there are 25,000 trees growing, a crop that, given natural mortality, he is unlikely to see mature. The trees are varied, including black walnuts and butternuts that take 15 years to produce a saleable crop and 60 or more years for saleable timber. David’s issues are deductibility of losses for his long-term investment and the problem of continuity of the enterprise after he is gone.
In one sense, he can afford to wait, for his current income, $79,280 per year or $6,600 per month after adding up his late wife’s pension survivor benefit, an armed forces benefit, CPP, OAS, RRIF income and adjusting for a small OAS clawback, is surplus to spending of $4,500 per month including generous gifts of $1,300 per month to his children and grandchildren. His problem is both one of profitability — lacking at present — and, of course, mortality.
David has two sons. They live far way and have their own financial concerns. He fears that capital gains taxes on his farm may diminish the estate he may pass to his children or to various good causes.
Farm Financial Planner asked Don Forbes, head of Forbes Wealth Management Ltd. in Carberry, Manitoba, to work with David. The immediate problem is whether the farm will qualify for the farmland capital gains exemption.
One can think of few crops that take longer to grow than trees. But David can afford to be patient. His net worth is $1.1 million based on $$700,000 real assets (half the trees, half his house) and $413,000 in financial assets. That works out to about two-thirds real assets and one third financial assets. In that allocation, his farm is not so different from that of farmers who have crops like grain maturing in years rather than in decades.
Any gain in the personally owned farmland will be offset by the $1 million Personally Owned Farm Land Capital Gains tax exemption and the allowable exemption of one acre and the primary residence — a value of perhaps $350,000. In total, that means $1,350,000 of capital gains on the farm and farmhouse will be exempt from federal income tax.
David’s children are not eager to become tree farmers, but their potential role in transfer of ownership has to be considered. As a farming parent, he can transfer land to the next generation at any price between book value and today’s market value. The best case is to use up all eligible tax credits and tax exemptions to raise book value to the current market value before transferring title to the next generation.
For example, David could transfer the land at a value of $700,000, take off the $350,000 value of the farm and one acre, a total of $425,000 including the plot, and realize a capital gain of $275,000. The exemption would offset the gain and leave zero federal tax payable. There may be some tax via the OAS clawback that starts at $75,910 at present and takes 15 per cent of each dollar of income over that amount until at about $123,000 all OAS is recaptured. On this basis, for the year that the capital gain is reported the entire present $7,290 OAS would be lost. As well, there may be some Ontario provincial income tax and the federal Alternative Minimum Tax. The AMT is recoverable as a credit for future tax years, Forbes explains.
There is a matter of qualification for the credit. The farmland must be a working farm. David has a certificate attesting to the farm being a federally provincially certified Managed Forest and thus a working farm. CRA likes to see attempts to make the farm profitable. If there are seven continuous years of losses, CRA may investigate to ensure that the farm may be profitable in future.
Should CRA determine that the farm is a hobby, then it will not allow deduction of expenses and past returns may be reviewed and more tax charged. CRA requires that the “farmer” make most of their income from the defined farming operation. The farmer must file a profit and loss statement with the annual tax return, have receipts to backup claims and other indicia of running a real business. One good idea is to have separate banking accounts for the farm, and also a farm business plan which indicates how the land can be used for the decades it takes for trees to mature into nuts or fruit or lumber or even as firewood derived from scraps and cuttings.
There are also some twists to observe in transferring land and trees to children. The kids can get the farm at book value because it is certified as a “Managed Forest” and can be backed by the evidence of running the farm as a business in annual profit and loss statements. The selection of transfer price depends on whether you select a low book value and thus give the children more space to generate capital gains — and be taxed on those gains — or a higher value that uses up your various exemptions. The lowest value is likely to be the municipal assessment value, $193,000.
Late in life, David’s issues devolve into estate management, the problem of passing on a very long-term asset to children and ensuring good care for the trees. The view is long term, for while trees take care of themselves rather more than crops which need annual plowing, fertilizing and pest management, the return on invested capital depends on the price and value of trees decades hence.
Given the farm’s annual deficit, $25,200, it would be possible to explore the idea of joint ownership for a future return with a neighbour who might look after the trees if David is no longer able or to set up a corporation that would employ someone to do the necessary work for pay. That would also increase the odds that CRA would accept the farm as a business rather than a hobby that has sprouted 25,000 trees.
David should run this plan by his legal counsel, of course. If on advice it seems that CRA may take a negative view of the farm as a business, David could consider donation of the land and trees to a suitable charity with proper documentation, CRA registration, a reasonable plan and a method of providing continuity for care of the trees. Gifts with proper documentation or, better, gifts to government units could allow David to harvest a gain appropriate to his concern for the environment.
Gifts of ecologically sensitive lands to the federal, provincial or municipal governments or approved registered charities can be made at the property’s fair market value for the purpose of the credit but with no capital gain recognized as a tax liability.
David is in a position to make wise use of this rather unusual agricultural property both for his own finances and for the benefit of the land and the country, Don Forbes concludes. The irony of the case is that David is unlikely to see the tree farm become profitable.