A couple we’ll call George and Mary have farmed in south-central Manitoba for the last 35 years on a third-generation family farm. Each is 60 years old. Their dilemma is generational transfer. Their issue is the fundamental low level of profitability that could, if not handled properly, cause the farm owner to lose their ability to deduct farm losses from other income.
George and Mary have 300 acres of certified organic grain and another 180 acres of pasture with 30 cows grazing. George and Mary have three children in their 20s, all with university degrees and accreditation in their professions.
George and Mary want to hand over the farm to two of their children interested in keeping the farm going. The youngest, 22, and the eldest, 26 are ready to carry on what their parents and grandparents built.
The problem is to structure the farm succession tax efficiently. For a farm not certain to make money, the tax rule which denies expense deductions to so-called hobby farms that do not make money could be an issue.
Three types of farms
To ensure that generational changeover does not lead the farm and the children who take it over into tax problems, George and Mary approach Don Forbes and Erik Forbes of Forbes Wealth Management of Carberry, Man., for advice.
“The issue is that for the last 70 years, Canadian tax policy has prevented persons who prefer a rural lifestyle from being subsidized by the Canadian taxpayer for money-losing farm operations,” Don Forbes explains.
Farm operations are structured for tax purposes into three categories, Don Forbes says.
1. Full-time farming: Full-time farming has normal business deductions for costs. The super capital gains deduction requires profitability two years out of seven. A minimum of $2,500 of gross farm income is need for either full-time or part-time farm status.
2. Part-time farming: Part-time farming status automatically occurs when non-farm income is more than half gross personal income. Farming losses are limited to 100 per cent of the first $5,000 of losses and 50 per cent of the next $5,000 for a maximum of $7,500 of losses that can be claimed against non-farm income. The two years out of seven profit rule is also relevant. The Canada Revenue Agency (CRA) is likely to audit returns when a farm has losses for seven or more years in a row. They ask why a farm is in business if it just generates losses.
3. Hobby farming: Hobby farming is the classification when the CRA considers the farm not a business. If there is no business plan, no profit and no prospect of a turnaround, all farm income is claimable as taxable income and expenses are disallowed as deductions.
Forbes suggests that neither child will run a profitable farm. Moreover, each child has a profession and an income. The farm would be a sideline and its losses would probably not qualify as deductible, Erik Forbes says.
Adding to the problem: George and Mary want to generate retirement income from the farm. They could buy a small store in a nearby town with a bank loan secured by a 160-acre parcel of land. They could get cash by selling cows, farm machinery and land to their children, but they prefer to transfer the land with a large discount on the price. They would sell the land at $500 per acre rather than the going price of $2,000 per acre and offer very flexible payment terms.
The problem with that generous offer is that the farming operation is not likely to generate much in the way of taxable profits. It is likely that the farm, as transferred, would generate losses and thus trigger the hobby farm barrier to deducting expenses.
The children taking over the farm will have to show a minimum of $2,500 gross farm income per year each year and make a profit two years out of seven to avoid the hobby farm loss exclusion rule.
As well, the farm and proposed store business should generate modest amounts of taxable income and tax liability each year so that tax deferral does not result in hefty tax on the estate after the parents’ deaths.
On transfer, the gain in personally-owned farmland will be offset by the $1,000,000 Personally Owned Farm Land Capital Gains Tax exemption for which George and Mary are eligible as well as the allowable exemption of the primary residence, the farmhouse and one acre of land. The sum, $132,000 perhaps, would make the total exemption $1.13 million, Erik Forbes estimates.
The parents can transfer land to their children at any price between book value and today’s estimated market value. That includes land, equipment and inventory.
The object is to use up all eligible tax credits and tax exemptions without claiming the entire market value of the farm and having to pay tax on it when transferred.
A good approach would be to sell 310 acres to one child at $2,000 per acre for a total price of $620,000. Take off the original cost at $150 per acre, $46,500, and the capital gain, $573,500, would be offset by the Capital Gain Tax exemption as discussed. Federal tax payable would be zero. Provincial tax is on a different schedule with different brackets and so could trigger some tax payable. There would be an Alternative Minimum Tax which could add $30,000 to tax on other net taxable income of $20,000. Total taxable income would be $50,000 and the Alternative Minimum Tax, say $12,0000, would have to be paid. But it would be a tax credit carry forward recoverable in the next seven years, Don Forbes explains. In the year of sale, Old Age Security would probably be clawed back.
A similar tax-management plan would work for the rest of the farm, though land used for collateral for an outstanding loan would be excluded from sale and transfer until the loan is paid.
It is prudent for the farming parents to take a zero-per cent interest promissory note on the land so that the parents’ financial interests are protected should either of the inheriting children get into difficulties with loans or divorce. Creditors or an estranged spouse could come after the value of the assets, but that person would have to pay off the parents before their claims would be considered, Don Forbes explains.
With these plans and provisions, the couple’s after-tax monthly income would be $3,272. If their living expenses are perhaps $2,000 per month, they could have a surplus to save for travel, a newer car, or gifts for their children or charities.