Structure for tax exemptions, let the son buy in at a good price and make sure there’s enough cash left to retire
At their ages of 62 and 56, a couple we’ll call Max and Daphne want to wrap up their life’s work farming in southern Manitoba. They own 1,120 acres of which 700 are planted to various crops, 300 in hay, and 120 in pasture. Their three children, all men in their 30s, will be part of their plans, though only one, Joel, is involved with the farm. Max and Daphne want to sell the farm to Joel in a way that allows Joel to carry it on as a viable operation.
Max and Daphne went to Don Forbes, a farm financial planner who heads Don Forbes & Associates/Armstrong & Quaile Associates Inc. of Carberry, Manitoba, to develop a plan for the transition. The goals: keep the farm intact and profitable, generate a retirement income for the parents and be fair to the non-farming siblings.
The problem in financial terms is that most of the capital Max and Daphne have built up is in the farm operation. They will have to sell some land for cash just to finance their retirement. Their goal is to have $50,000 per year in pre-tax retirement income and buy a house in town.
If they sell 640 acres of cropland and pasture to any interested buyer, they would still have another 460 acres that could be sold to Joel on favourable terms. The land sold to an outsider would fund an investment account.
The best plan: restructure the farm as a partnership with Daphne, who is currently Max’s employee. This will make Daphne eligible for the $750,000 farm land capital gains tax exemption, giving Daphne and Max a combined total exemption of $1.5 million. This exemption will minimize any additional tax burden from sale.
An alternative is to have Joel (the farming son), or even all three sons buy out the parents. To make this work, Max and Daphne would need to guarantee the loans the sons would obtain from a bank or other financial institution. This would put the plan in peril and be unduly complex.
Transitioning to the farming partnership to obtain the $750,000 per person capital gains exemption) will require that Max and Daphne carry on for two more years. That will generate the required two years of farm income statements. The income generated should be held in accounts to pay off remaining debts — really just $16,000 of loans — and to maximize RRSP contributions.
Two years from now, the remaining farm operations will be prepared for sale or transfer to their farming son. That would require sale of four quarters of land at a fair market value of $1,000 per acre. That would bring in $640,000. $300,000 of this could be reserved for purchase of a house in town. The remaining $340,000 would produce $17,000 per year if invested to generate a five per cent annual return.
After that, Daphne and Max could sell as much as the remaining three quarters of land to Joel for a reduced price or at fair market value. They would still be able to stay under the $1.5 million combined limit of the farmland capital gains tax exemption. Land that is not sold can be kept for cash rental, Forbes suggests.
Max and Daphne should contribute $9,000 each to their RRSPs and make $5,000 contributions each to Tax-Free Savings Accounts, which they have never used, every year from now until Max is 65 in the three years after they begin selling their land. Then they will have $322,471 in non-registered and TFSA accounts, and $253,467 in RRSPs.
Max and Daphne can accelerate growth of registered assets by ensuring that they do not wait until the end of the 60-day grace period each year, thus making use of potential growth within the year. Their annual contribution limit is the lesser of 18 per cent of gross earned income or $23,820 in 2013. By making RRSP contributions every month or every quarter Max and Daphne will in effect be cost averaging over 14 months (the year plus the two-month grace period) and thus avoiding the peaks and valleys of the stock and bond markets.
At Max’s age 66, the first year after he has retired, the accounts will support monthly income as follows: Max will have Canada Pension Plan payment benefits of $8,040 per year and Old Age Security benefits of $6,720 per year. He will be able to make $7,200 annual withdrawals from his Registered Retirement Savings Plan. And they will have $17,000 per year investment return from cash not used to buy a new house in town. Their pre-tax retirement income would be $38,960. Daphne can add $7,200 from her own RRSP for total income before tax of $46,160. They can supplement this income with rent from any land not sold, pushing up total pre-tax income to their $50,000 goal.
At her age 65 Daphne can receive $4,800 in annual CPP benefits. She can add $6,720 per year from OAS, which will have risen with inflation. Their income at this point would be $57,680. After tax at a 12 per cent average rate on what amounts to split and averaged incomes, they would have $4,230 to spend each month.
It should be noted that the Income Tax Act allows the intergenerational transfer of land to be priced at anything between fair market value of the land and book value. The current market value pricing would allow the transfer to be tax-free in the parents’ hands. The son would have a higher cost base and would thus be exempt from more capital gains tax in future if he were to sell, Forbes explains.
Investing to obtain a secure and consistent five per cent annual return would be achieved by use of 10-year investment grade corporate bonds with returns of 4.5 per cent, rate reset bank bonds that are constructed to pay three to four per cent over specified interest rates such as the Bank of Canada overnight rate, and shares of large cap Canadian corporations — telecom companies, banks and pipelines, for example, that have not failed to pay dividends for 10 or more years and that have raised dividends at least every two to three years. No sector should hold more than a fourth of the total capital and the various stocks should be rebalanced every couple of years so that no single stock is more than 10 per cent of the portfolio.
The chore of stock and bond selection can be made much easier by use of exchange traded funds that hold so-called dividend aristocrats, that is, stocks that have secure and rising dividends, and laddered one- to 10-year corporate bonds.
Laddered bond funds’ cash yields can rise as interest rates go up. The effect of rising interest rates on existing bonds, making them less appealing and so cutting their prices, is compensated by holdings of short bonds reverting to cash in a few years. Fees for both types of ETFs are in the range of three- to five-tenths of one per cent per year. If Max and Daphne buy the funds through on-line discount brokerages, shrinkage due to sales commissions would be trivial, Forbes notes.
This plan will turn a family farm into a secure retirement income for Max and Daphne and enable one son to continue farming. Joel could rent the land the couple will have to sell and, if fortune smiles, eventually repurchase some or all of it.
The interests of all three sons can be protected by having all three inherit an equal share of the retirement home Max and Daphne will buy. As well, any money left in their various investment accounts, which are likely to grow in value over time beyond Max and Daphne’s requirements, can go to the sons.
“This is an equitable and efficient plan for Max and Daphne and their children,” Forbes says. “If they follow the suggestions, it should be easy to implement and easy to maintain.” †