Farm transfer of an unprofitable farm could lead to “hobby farm” status and tax challenges.
This article was originally published in Grainews. Grainews is an agricultural based publication written for farmers, and often by farmers, in a style they understand. Don and Erik work closely with author Andrew Allentuck, providing the background financial plans and theoretical analysis for Andrew’s Farm Financial Planner column.
For the last farm financial planner article read: Farm Financial Planner: Estate Planning.
A couple we’ll call George and Mary have farmed in south-central Manitoba for the last 35 years. The farm is a third-generation family farm. Both are 60 years old and their dilemma is generational farm transfer. The issue is the fundamental low level of farm profitability. If not handled properly it could cause the farm owners to lose their ability to deduct farm losses from other income.
George and Mary have 300 acres of certified organic grain and another 18- acres of pasture with 30 cows grazing. They have three children in their 20’s, all with university degrees and accreditation in their professions.
George and Mary want to hand over the farm to two of their children interested in keeping the farm going. The youngest, 22, and the eldest, 26, are ready to carry on what their parents and grandparents built.
The problem is how to structure the farm succession tax efficiently. For a farm not certain to make money, the tax rule which denies expense deductions to so-called hobby farms could be an issue.
Three Types of Farms
To ensure that a generational farm transfer does not lead the farm and the children who take it over into tax problems, George and Mary approached us for advice.
The issue is that for the last 70 years, Canadian tax policy has prevented persons who prefer a rural lifestyle from being subsidized by the Canadian taxpayer for money-losing farm opertaions.
Farm operations are structured for tax purposes into three categories;
- Full-time Farming: Full-time farming has normal business deductions for costs. The super capital gains deduction requires profitability for two out of seven years. A minimum of $2,500 of gross farm income is needed for either full-time or part-time status.
- Part-Time Farming: Part-time farming status automatically occurs when non-farm income is more than half the gross personal income. Farming losses are limited to 100% of the first $5,000 of losses and 50% of the next $5,000. This amounts to a maximum of $7,500 of losses that can be claimed against non-farm income. The two years out of seven profit rule is also still relevant. The Canada Revenue Agency (CRA) is likely to audit returns when a farm has losses for seven or more years in a row. They ask why a farm is in business if it just generates losses
- Hobby Farming: Hobby farming is a classification when the CRA considers the farm, not a business. If there is no business plan, no profit and no prospect of a turn-around, all farm income is claimable as taxable income and expenses are disallowed as deductions.
We suggested that neither child will run a profitable farm. Moreover, each child has a profession and an income. The farm would be a side-income. The farm would be a sideline and its losses would probably not qualify as a deductible.
Adding to the problem; George and Mary want to generate retirement income from the farm. One option is to buy a small store in a nearby town with a bank loan secured by a 160-acre parcel of land. They could get the cash by selling cows, farm machinery and land to their children. However, George and Mary prefer to transfer the land with a large discount on the price. They would sell the land at $500 per acre rather than the going price of $2,000 per acre and offer very flexible payment terms.
However, there is a problem with that generous offer. The farming operation is not likely to generate much in the way of taxable profits. It is likely that the farm, as transferred, would generate losses and thus trigger the hobby farm barrier to deducting expenses.
The children taking over the farm will have to show a minimum of $2,500 gross farm income per year each year. Furthermore, they will have to make a profit two years out of seven to avoid the hobby farm loss exclusion rule.
As well, the farm and proposed store business should generate modest amounts of taxable income and tax liability each year. Thus, tax deferral will not result in a hefty tax on the estate after the parents’ deaths.
Properly structured, the well of the parents’ wealth will not run dry. Tax management is the key.
On transfer, the gain in personally-owned farmland will be offset by the $1,000,000 Personally Owned Farm Land Capital Gains Tax Exemption for which George and Mary are each eligible for. In addition, they are also eligible for the allowable exemption of the primary residence, the farmhouse and one acre of land. The sum, $132,000 perhaps, would make the total exemption $1.13 million.
The parents can transfer land to their children at any price between book value and today’s estimated market value. That includes land, equipment and inventory.
The objective is to use up all eligible tax credits and tax exemptions without claiming the entire market value of the farm and having to pay tax on it when transferred.
A good approach would be to sell 310 acres to one child at $2,000 per acre for a total price of $620,000. Take off the original cost at $150 per acre, $46,500. You are left with a capital gain of $573,500. This capital gain would be offset by the Capital Gain Tax exemption as discussed. Federal tax payable would be zero. Provincial tax is on a different schedule with different brackets and so could trigger some tax payable. There would be an Alternative Minimum Tax which could add $30,000 to tax on other net taxable income of $20,000. Total taxable income would be $50,000 and the Alternative Minimum Tax, say $12,000, would have to be paid. But it would be a tax credit carry-forward recoverable in the next seven years. In the year of the sale, Old Age Security would probably be clawed back.
A similar tax-management plan would work for the rest of the farm. However, land used for collateral for an outstanding loan would be excluded from sale and transfer until the loan is paid.
It is prudent for the farming parents to take back a zero-percent interest promissory note on the land. This ensures that the parents’ financial interest is protected should either of the inheriting children get into difficulties with loans or divorce. Creditors or an estranged spouse could come after the value of the assets, but that person would have to pay off the parents before their claims would be considered.
With these plans and provisions, the couple’s after-tax monthly income would be $3,272. At an assumed $2,000 per month lifestyle, they could have a considerable surplus. This could be used to save for travel, a newer car, or gifts for their children or charities.
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