A couple we’ll call Lisa and Herbert emigrated to Canada 34 years ago. They left a small farm in England and bought a 1,120 acre farm in central Manitoba. With their children, a daughter, now 51, and a son, now 48, they ran a mixed grain and beef operation. Herbert passed away in 2010. Lisa, now 77, faces the challenge of generational change. At present, the farm land is rented to a neighbour.
Lisa’s daughter, married and with her own children, wants to build a home on a quarter adjacent to their farm’s home quarter. Lisa thinks that would be a good idea for companionship and assistance. Lisa and Herbert’s son would like to help run the farm. The problem is to make a plan for generational change and a fair division of the family estate while Lisa is still living.
Lisa sought the assistance of Don Forbes and Erik Forbes of Forbes Wealth Management Ltd. in Carberry, Manitoba.
Money is not a problem for Lisa. She receives a British pension with a current value of $3,000 per month. The transfer of value to the children will be easier in financial terms thanks to the provision in the Income Tax Act that allows transfers between parents and children or grandchildren to be at any value between the book value, $579,650 in this case, and the current market value. The Farm Land Capital Gains Tax Exemption allows $1 million tax-free, so the total value of the land transfer could be as much as $1,579,650 before triggering taxes Erik Forbes says.
The amount the children may have to pay would be termed “consideration” and could be as little as $1. This payment could be structured as a loan with no interest payable and the loan forgivable on Lisa’s death. Land rental income could be paid to Lisa in lieu of interest payable on the promissory note. If Lisa does not need the money, she can gift it to the two children, Don Forbes adds.
The increased value of the land is the transfer value. It becomes the book value for the children. They are responsible for tax on any future increase in the value of the land. Structuring the transfer in this fashion means that if either child were to encounter marital problems or an insolvency, there would be no claim on the original value of the land as transferred. The claim on the value of the promissory note would have precedence on a subsequent claim by creditors, Don Forbes says.
Although assets can be protected by this means, the Alternative Minimum Tax or AMT will create a tax liability if Lisa uses her large capital gains tax credit to offset capital gains on her farm land. The AMT would be triggered if Lisa declares $320,000 or more in income in a calendar year.
Although a small part of the capital gain will generate an AMT liability, the amount paid will still be covered under the Farm Land Capital Gains Tax Exemption. It will become a component of the tax paid credit account with the Canada Revenue Agency. It amounts to prepaying some future tax, Erik Forbes explains. The credit will be on the CRA’s records and can offset future federal tax over the next 10 years. Thus it could be advantageous for Lisa to continue to receive farm land rent until the CRA tax payable credit balance is exhausted.
There are other tax control strategies. Lisa could gift the land in parcels to the children and thus declare just a part of the capital gain each year. This process could keep the tax due below the AMT threshold each year. The alternative is to transfer all gift parcels less the home quarter in one year and thus create a capital gains reserve of which a small part would be declared each year for five years, Don Forbes says.
This process comes at a price, however. On a $1 million transfer value with $200,000 declared each year, there would be a cost, for Lisa would not be eligible for Old Age Security for five years. Her income would be consumed by the clawback, which starts at about $74,750 next year and takes back all OAS when income is over about $119,600, Don Forbes says. The clawback is indexed, he adds.
This plan for transfer of the family farm to two adult children with asset protection in the event of marital difficulties or insolvency can produce income sufficient to cover Lisa’s monthly $3,000 living costs. Lisa will undoubtedly have more income than that. She can use a Tax-Free Savings Account to shelter savings. Money withdrawn from the TFSA is not counted as income and thus does not trigger the Old Age Security clawback, Erik Forbes explains.
The added benefit of the use of a TFSA is that the children can be designated as beneficiaries. So adding funds to $46,500 in 2016 and $5,500 per year for each additional year can be both an intergenerational transfer mechanism and a way to hold an emergency cash reserve.
For now, the land transfer should go ahead so that the value is split over two years. The AMT tax liability generated, perhaps just a few thousand dollars, is a credit for federal tax payable in 2018. Lisa can take a promissory note for the transfer value protect retirement income and to insulate the children from any claims against their inheritance.
Finally, land rental income can be held for Lisa’s personal use. It will be taxed in her hands in order to use up any remaining AMT credit. Any after-tax money can be given to the children if Lisa so wishes, Don Forbes adds.
In dollar terms, there is a lot of flexibility. Lisa’s present income with land rental is $70,000 with an estimated $22,000 tax liability. If all land is transferred in one year, Lisa’s gross income would rise to $307,665 and her total tax would be $40,845 with an AMT of $40,845 and $5,200 of extra provincial tax. While the AMT is recoverable in future returns, the extra provincial tax is not recoverable. It is just a tax surcharge, Don Forbes explains.
If Lisa does the transfer over two years, her gross income would be $198,900 per year and her tax liability would decline to $25,500 with AMT of $2,140 and just over $1,000 of extra provincial tax per year. If the transfer is done over three years, her gross income per year would be $158,900 with $22,300 of total tax and zero AMT. Time and patience are clearly virtues in this transfer process, Erik Forbes notes.
The home quarter and its yard are not part of the transfer process. This can be dealt with in Lisa’s will and retained as a source of capital should Lisa need to raise additional money for care later in life.
“This is a plan for a widow who has substantial capital ties up in her farm and two children willing to take over the operation,” Don Forbes explains. “We have created a choice of strategies for tax minimization. There is some paperwork involved, but it is really a simple plan with few unknowns and very little risk.”