Most people have heard about the capital gains exemption, but they are not always familiar with the benefits the exemption can provide.
In particular, producers may not be aware of how their capital gains exemption can be used in conjunction with other tax planning strategies to limit or defer income tax on their farming operations.
The exemption allows individuals to deduct up to $750,000 of capital gains from their taxable income on the sale of qualified farm property. This means that the taxable gain created when they sell farm property (proceeds less cost) can be reduced by up to $750,000. Qualifying property can include farmland, buildings and shares in a farm corporation.
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The capital gains exemption is usually triggered when the farm is sold to raise money to retire.
However, what if the farmer doesn’t want to sell the farm, but rather pass it on to his children or grandchildren? In this case, the exemption can be combined with other tax planning strategies to minimize potential tax liabilities.
A common strategy is to use special transfer rules in combination with the capital gains exemption. The transfer rules, or what is often referred to as the rollover provision, allows producers to transfer their farm property to their children, potentially without tax consequence.
Farm property is usually considered to have been “sold” at fair market value when transferred to anyone other than a spouse. This often creates taxable income for farms because the fair market value is higher than the original purchase cost.
The rollover provision allows property to be transferred at any amount between the original cost and the fair market value. This allows farmers to control the amount of taxable income generated by the transaction.
To illustrate the benefit of combining these tax planning tools, consider the following situation.
A producer owns a farm that qualifies for both the capital gains exemption and the rollover provision. The farm has been successful and the producer wants to sell it. He acquired the farm 25 years ago for $250,000 and the market value has since risen to $1.25 million.
If the producer sold it at market value, his capital gain would be $1 million and he would face a tax bill of 50 percent if he used neither tax planning tool.
The capital gains exemption would subtract $750,000 to reduce the taxable capital gain to $250,000.
Consider the same situation, but instead the producer decides to transfer the farm to his child, combining the capital gains exemption and the rollover provision.
With the rollover, he would choose an amount between the original cost and the fair market value. If he chose a cost of $1 million, he would subtract the original cost of $250,000 to get a capital gain of $750,000.
The producer could then apply the $750,000 capital gains exemption, eliminate the capital gain and pay no tax on the transfer. There is a small recoverable tax called alternative minimum tax that may potentially apply, depending on the situation.
By combining the capital gains exemption with the rollover provision, the producer also minimizes the tax bill for his children when they sell the farm in the future. This is because the new cost base on the farm property would be $1 million. Therefore, the child will pay tax only if they sell the property for more than $1 million.
Combining these tax planning tools helps family farms limit and defer their tax liability on the sale or transfer of their farm property.
In situations where producers and their spouses jointly own farm property, there is potential for both to take advantage of the capital gains exemption.
The rules for capital gains exemption and the rollover provision are complex. Special consideration needs to be given to producers’ specific situations. Therefore, they should consult a tax adviser to determine if they qualify to use these tax planning tools, and to determine the most effective strategy to apply them.
Colin Miller is a chartered accountant and senior manager in KPMG’s tax practice in Lethbridge. Contact: colinmiller@kpmg.ca.
