Tapping capital gains deductions associated with selling qualified farm property might be an appealing way for farmers to reduce their tax bills on such sales. But the calculations surrounding these deductions are so complicated and detailed that you might get a lot less than you bargained for, including reduced benefit from the $1 million enhanced capital gains exemption (CGE).
At the heart of the problem is cumulative net investment losses (CNILs). These little and sometimes not so little items work to drive down capital gains exemptions. They are largely forgotten until it is time to file a CGE claim.
Something as simple as continually claiming interest expense as a deduction on investment income gets cumulatively subtracted from a CGE claim. Allowable business investment losses also grind down the CGE claimed in past years. Part of the problem is that interest and carrying charges are deductible for income tax purposes but become an issue when calculating capital gains exemptions.
Since 1988, net investment losses have been calculated on a cumulative basis. If the aggregate of investment expenses is greater than the aggregate of investment income, a loss occurs. But what if the cumulative total of some of those expenses must now be absorbed when claiming a capital gains deduction on the sale of qualified farm property? Then the CGE takes a hit.
Some of those investment expenses include deductions for the cumulative total of interest and carrying charges on property that yields interest, rent or other property income and losses either from the property itself or leasing of property owned by you or by a partnership in which you are involved.
There are options to minimize the impact of a CNIL. As a shareholder you might charge interest on shareholder loans to corporations as a means of offsetting investment losses. You can also reduce CNIL exposure if, as a shareholder-manager, you take income in dividends instead of salary. Deferring interest payments to the following year will have a similar effect.
If you’re a sole proprietor or active member in a partnership there is another option. If you finance investments by taking distributions from the partnership and then replace the distribution with borrowed money, the interest on the loan is not considered part of the CNIL.
Did we say all of this is complicated? The ability to maximize a lifetime exemption is limited by something else called the cumulative gains limit. This is a measure of the taxable portion of net economic gain since 1985 that is eligible for exemption but only after deducting prior gains claimed for exemption and the application of CNIL rules from 1988 onward.
Before selling the property in question, seek advice on how CNIL will affect the capital gains deduction.
Grant Diamond is a tax analyst in Saskatoon, SK., with FBC, a company that specializes in farm tax. Contact: email@example.com or 800-265-1002.