In a small settlement west of Winnipeg’s Perimeter Highway, a widowed farmer we’ll call Ralph, 63, has a dilemma. He is not ready to retire just yet and out of his four children only the youngest, a son we’ll call Herb, has his own farm and would be interested in taking over Ralph’s farm, which is a 2,000-acre spread in mixed pasture and grain.
Ralph has total net worth of $7,537,357, almost all of which is his farm and personal land plus a house and cottage worth a combined $340,000. His financial assets total a modest $218,000. The farm and its inventory are Ralph’s financial life.
Selling land would generate a hefty capital gain. Ralph wants to minimize the tax. To that end, he approached Winnipeg-based certified financial planner and farm advisor Colin Sabourin for advice.
The issues in the potential sale of pasture to the interested buyer, the City of Winnipeg, are complex. Ralph wants a good price and a way to reduce capital gains tax on the potential sale. Price is an issue, but so is the bidder’s right of expropriation. This is a transaction that is going to happen. Only how it happens is an issue.
The City of Winnipeg wants to build a new development on some of Ralph’s land. The City has offered $25,000 per acre for 40 acres. That’s $1 million. Ralph paid $60,000 for the land, so his potential gain is $940,000. Ralph has $700,000 of capital gains exemption. He previously used $300,000 of the $1 million allowed under the Qualified Farm Property Lifetime Capital Gains Exemption.
Ralph’s remaining land has an adjusted cost base of $1,000 with a fair market value of $3,108,000. Ralph’s corporation is valued at $3,061,357 and it qualifies for the capital gains exemption because it has more than 90 per cent of its assets in the farm.
A Cinderella issue
Ralph’s four adult children have their full $1 million capital gains exemptions remaining. One child, a daughter who does not want to farm, can receive 40 acres. If the daughter owns the land for at least three years, she can use her own $1 million exemption, Sabourin notes.
The adjusted cost base of the land is $60,000, so upon sale, the gain of $940,000 could be sheltered by using the daughter’s capital gains exemption. The proceeds could then be gifted to Ralph free of tax. Canada, of course, has no gift tax. A non-farming daughter is the best recipient of the gift because the son, Herb, will farm and will want to use his own exemption at some time in the future.
The question of which daughter should get the gift of 40 acres resembles a Cinderella issue. Tax exemption is the glass slipper in this case.
Daughter No. 1 may want to use her exemption some time in the future for her own business. But she has distinct creditor risk. If her business were to fail while she owns the farmland, a creditor could reach to the land.
Daughter No. 2 is married with children. If she were to own the land and rent it back to her dad, her income would be taxable and would reduce the Canada Child Benefit.
Daughter No. 3 is not married and has no children. She cannot lose land in a divorce settlement. She does not receive the Canada Child Benefit. She is the best candidate to inherit the land.
Four years from now, when daughter No. 3 can sell and apply the Qualified Farm Property Exemption, the City of Winnipeg will, we assume, have written a cheque for $1 million to the daughter. She can claim a $940,000 gain and offset it with her own exemption. She can gift the money back to Ralph. He will still have $700,000 of his own exemption remaining. She will have to pay the Alternative Minimum Tax (AMT) of about $50,000 for the transaction. Daughter No. 3 can cover this by gifting $890,000 and leaving $50,000 to pay the tax. The AMT, a tax equalization that functions as a tax deferral, can be applied for the next seven years to reduce her taxes.
This plan is a lot of paperwork, but it will save Ralph approximately $20,000 in taxes, Sabourin estimates.
There is a caution we have to mention. The four-year hurdle should work, but the capital gains exclusion rate of 50 per cent could change as the Government of Canada seeks tax revenue to compensate for its huge expenses coping with the COVID-19 pandemic. Among the changes that could be made are a cut in the 50 per cent capital gain exclusion to 45 or 40 per cent or less. Base tax rates could rise. Ralph will be 67 and presumably in receipt of Old Age Security (OAS) and Canada Pension Plan benefits.
Assuming that Ralph gets a three per cent return after three per cent inflation from his $7,387,575 of assets, $221,630 before tax, he can retire in comfort. At 65, he will qualify for Old Age Security, $615 per month at 2021 rates, but lose all of it to the clawback that starts in 2021 at $79,054.
The clawback takes all OAS at yearly income of $128,149. He will be able to add $14,000 per year from the Canada Pension Plan. That’s a total income of $235,630 post 100 per cent clawback. After regular income tax at 39 per cent and clawback, he would have $143,734. When he gets the $940,000 from his daughter, its income, also at three per cent after inflation, $28,200 per year before tax and $17,200 per year or $1,433 per month after 39 per cent tax, would push Ralph’s after-tax income to $13,411 per month.
That’s without realization of any capital gains on farm property. He is an ideal candidate for making charitable donations given that his tax rate is high and what he gives is effectively eliminated by tax deductions.
Ralph’s legacy to his children can be the farm, a lot of cash and perhaps a connection to a community benefactor.