A reader from Ontario is getting close to retiring and asked me by email how he should think about his farmland. Should he keep it all and rent it out, sell some or sell all of it? He also suggested that many farmers likely face the same question so I told him I would write an article for Grainews readers.
I think retiring farmers need to answer several questions: Will you need cash flow from your money? Do you have to protect the capital gains exemption? Are you looking for something to do after you retire? I will address each question but it will take two articles. This is part one. Part two will run in the May issue of Grainews.
The article “Multiply the capital gains exemption” in the March 8 issue of Grainews helped large-scale farmers understand how to create more tax exemptions when they sell farmland. That was well done.
While the coffee shop talk might make you think you’re going to pay an arm and a leg in taxes if you sell your farm, if you’re a smaller farmer I hope you can see that you might not pay any extra taxes if or when you sell your farm. You might lose your supplement, and your Old Age Pension might be clawed back for a year but that might be the only cost when you sell your farmland.
But I think there’s more to selling your farmland than just the question of how much tax you might or might not pay. I will cover a few of those points in this article.
I think the farmer from Ontario, you or any other farmer need to think in several steps: Will you need more cash flow? Have you used your tax-free exemption and, What are the other tax implications? Will you need to keep “farming” to protect capital gains exemption on some farmland? Are you willing to learn a new skill?
If you want cash flow and are willing to learn a new skill you could set up a strategy where you sell some land to raise money. Then you could invest in four ways: A Tax-Free Savings Account; a trading account; some fixed income assets; and then crop share the rest of your farm so you’re farming as far as Canada Revenue Agency is concerned.
The main thing is you can do as many of these as you are prepared to learn and do. But if you did all of them you would have several streams of income, you’d still have some of your farm and qualify to be a farmer and you’d have something to do to keep your hands and mind busy.
PROTECT THE EXEMPTION
The question about protecting the tax-free exemption on farmland really goes back to how long your farm has been in the family. If you or your parents, or grandparents, or even great-grandparents farmed before 1987 then you really don’t have to worry about protecting the exemption. You are grandfathered and so are your children and grandchildren (direct descendants), however any farm-land that you did not farm before 1987 is not grandfathered so you might need to sell the farm as you retire to use the capital gain exemption.
Or you might have to keep farming under some sort of crop share agreement or other business arrangement so you keep filing a farm tax return. That is one key to any strategy. Under the crop share agreement you would need to share some of the risk.
CASH FLOW CONSIDERATIONS
My first thoughts go to the question: do you need or want cash flow when you retire or slow down from farming? Most farmers don’t have a pension plan and if they managed their taxes on the cash basis maybe they didn’t pay much into Canada Pension Plan (CPP) so the payout won’t be very big there. And the Old Age Pension (OAS) of $516 per month doesn’t go as far as it used to. If you need cash flow, how much per month?
If you need cash flow there likely are two ways to get it. One way is to sell the farm, deal with the taxes and then invest the money to bring in cash flow. The problem is many managed accounts have not made much money the past few years and interest income is very low at current rates of interest.
If you sell your farm and collect half a million or a million dollars, how are you going to invest the money? Will you rely on a financial institution? Will you just put the money into the local credit union or bank to collect two per cent per year more or less? I do hear from readers that they earn something close to five per cent if they have a lot of money and lock it in for up to five years.
As for money on short-term deposit we all know income is low especially after income tax and some inflation. When it takes a million bucks to earn $20,000 per year I think you can see that cash flow from a million bucks doesn’t go far. The other day a reader called to say his bank wanted him to invest his Tax-Free Savings Account to earn 1.2 per cent per year.
Some people complain about financial advisers but they seem to forget they didn’t want to learn how to manage their own cash 10 years ago. They also forget that perhaps they have money saved up because a financial adviser helped them set up an RRSP, or buy mutual funds and so on.
I don’t know if an investor should expect unmanaged money to earn much more than the low rates we see today. And if you have someone manage your money because you had no time or didn’t want to learn how to do it yourself then you should expect to pay a fee for that service.
If your cash earns a low income, chances are you will be drawing down your principal but hey if you start with a million bucks maybe that’s OK. However if you start with $200,000 and you’re only 66 years old, you might outlive your money, unless you can set up something where your money earns more.
If we go by the idea that a couple likely needs around $30,000 of taxable dollars per year to live, and your OAS and CPP pay you $1,500 per month, you will need an extra $1,000 to $1,500 a month. In 10 years you might need $1,500 or $2,000 a month. And if you need $50,000 a year you certainly will be drawing down capital. That could be after tax money which would reduce how much money you need.
This might be a good time to pencil out income and expenses now and when you retire.
HOW TO SET UP PERMANENT CASH FLOW
How do you set up a system so you have permanent cash flow? First I have to ask the question: is your farm grandfathered? If it is and if it was me I likely would sell some farmland to use some or all of my tax-free capital gain exemption and look for a good farmer who wants to add land to his farm and has the equipment and managerial ability. Then I’d set up a rental agreement where I collect some rent and have little risk.
I say this because I think the price of farmland is going to go up and if you can manage it, why not keep some land for cash flow and capital gain.
If your farm is not grandfathered then I would need a different strategy. First I would likely sell as much land as I need to use most or all of the capital gains exemption while I was farming. Of course if I didn’t have enough land to sell to fill that exemption then I’d have to decide if I wanted to just get out of farming or stay in to protect the exemption.
If I chose to keep some land then again I would look for a good farmer with good machinery and management ability and I’d try to set up a crop share agreement where I as the owner of the farmland share some of the risk while the tenant does the work. That would let me, the land-owner, continue to file a farm tax return and that will preserve the capital gain exemption. After I leave this fine place our children might want the cash flow and the capital gain exemptions and they might want to continue this practice. If not they could sell the farmland and still use the rest of the capital gains exemption because I was farming the land.
THE GRANDFATHER CLAUSE
There is a lot of misinformation on the tax-free capital gain exemption, and I hope I don’t add to that misinformation. As I understand the tax laws, as long as someone in the family farmed the land before 1987 then the owner of the land or his direct descendants (children and grandchildren) qualify for the exemption. This is called the grandfather clause. Actually I think the better way to describe it is that grandfathered farmland carries the capital gain exemption regardless of which direct descendant owns the farmland.
With the grandfather clause the direct descendent should certainly qualify for the exemption whether he or she farmed the land or not. But the spouse of a descendent might not qualify unless he or she worked with you on the farm, which isn’t that hard to set up. In a sense it’s a matter of timing. If your farmland is grandfathered then you don’t have to be farming to qualify for the exemption. But if you, the direct descendant, die your spouse isn’t grandfathered. That’s why you as a couple likely should farm as partners so she would qualify for the exemption. Actually I don’t know if CRA would challenge any split or sharing of capital gain between spouses but it might be wise to be safe.
Therefore it stands to reason that many farmers who have farmed the land with a spouse would or could sell their whole farm and they might not even use all of the exemption of $750,000 each. If the farm sold at a price where the capital gain was less than $1.5 million the capital gain exemption would offset all of the capital gain and there would be no tax to pay.
Even though there is much fear and gnashing of teeth over the sale of farmland, smaller farmers have little or nothing to fear from the tax-man if they sell their farm. But it would pay to sit down with a person who knows farm tax laws to discuss the strategy in detail and put down all fears.
One finer point: As I wrote before, in the year you sell your farmland and trigger capital gain you might lose your supplement income or Old Age Pension for one year even if you paid no income tax on that gain.
Also there is a minimum tax clause if you suddenly have a big lump sum or taxable income but I have never seen that tax triggered yet by the sale of a smaller farm.
Sadly many in the financial and tax business do not understand the grandfather clause so again be sure to talk to someone who knows. And if the first person you talk to doesn’t understand the rules then by all means keep looking.
Andy is mostly retired. He manages his own portfolio and publishes an investment newsletter called StocksTalk where he tells what he does in detail. If you want to read StocksTalk free for a month go to Google, type in StocksTalk.net,click on StocksTalk, click on Form and fill out four lines of information and click submit.