Taxation on the Sale of Farm Business Assets
Table of Content
This Factsheet provides information to farmers who are considering the sale of their farming assets. It applies to sales to family members or strangers that occur at fair market value.
For information on transferring farm assets to family members when the assets are being sold for less than their fair market value, see the OMAFRA Factsheet Taxation on the Transfer of Farm Business Assets to Family Members and the Farm Succession Planning Guide, Publication 70.
This information is intended for planning purposes only. It does not replace professional advice from a tax specialist.
The sale of inventories such as crops, supplies and livestock is included in income just as other product sales are. Farmers have the choice of reporting their income for tax purposes on either a cash or accrual basis1.
Inventory Sales - Tax Filed on a Cash Basis
The following cash-basis deductions from income may be available when inventory is sold.
A Basic Herd Deduction2
This deduction, for mature animals owned prior to 1972, will likely have been fully used by most farmers, however, some may still have it available to them. Old tax files must be referenced to determine what the 1971 basic herd value was. If these are not available, the regional Canada Revenue Agency (CRA) office may be able to supply that information. The calculation is based on a per-animal basis. For instance, a dairyman with 30 basic herd units at $800 in 1971 would have a deduction of $24,000.
An Optional Inventory Adjustment3
This inventory adjustment allows you to add a portion of your inventory value to your current year's revenue and then claim it as a deduction in the following year. This is useful if your current year's income is lower than normal and you wish to have some income taxed in the lower tax brackets. If income is higher the following year, you can use the deduction to reduce income and lower the tax paid. To determine if an optional inventory adjustment is available for the current year, see line 9941 of your Statement of Farming Activities, included with your previous year's income tax filing.
Summary of the tax implications of selling farm assets
A Mandatory Inventory Adjustment4
In the year a cash loss occurs, you must decrease the loss by the amount of inventory purchased that year that is still on hand at year end. This is called the Mandatory Inventory Adjustment (MIA), and its purpose is to prevent the creation of a loss by simply purchasing inventory. If you reported a mandatory inventory in the previous year, it can be deducted in the current year. To determine if a mandatory inventory adjustment is available, see line 9942 of your Statement of Farming Activities included with your previous year's income tax filing.
Inventory Sales - Tax Filed on an Accrual Basis
Paying tax on capital gains
Payment of income tax on capital gains began January 1, 1972, often called V-day (valuation day). Gains and losses are calculated on the difference in value between the adjusted cost base (ACB) and the sale price of capital property such as farmland, rental properties, stocks and personal property. Depreciable property, such as machinery, equipment and buildings, is subject to capital gains but cannot incur losses. For example, selling a machine for more than the original cost results in a capital gain. If it were sold for less, the loss on the sale is not deductible for tax purposes. The exception to this is when a complete class of assets is sold for less than the undepreciated capital cost balance in that class, resulting in a terminal loss (see Section 3 for details).
Adjusted Cost Base
To calculate a capital gain or loss, you must know the adjusted cost base (ACB). This is the amount deducted from the selling price to determine a capital gain or loss. For property obtained before 1972, the ACB is the greater of original cost or the December 31, 1971, value. If obtained after 1971, the ACB is the purchase price plus costs. The cost base of land is adjusted by adding any non-depreciable capital improvements, legal and realty fees to the adjusted cost base. The ACB of buildings is increased by any capital improvements or additions, beyond just the normal maintenance and repair. An example of a capital gain calculation follows:
Taxation of Capital Gains
50% of a capital gain is tax free. The other half of a capital gain is subject to regular tax. This portion, called the taxable capital gain, is added to all other income in the year the gain occurs. Any allowable capital losses can be deducted from the taxable capital gain. If the capital gain occurs on a corporately owned asset, 50% of the gain is tax-free and is allocated to the Capital Dividend Account. Dividends from this account are received tax-free by the shareholder. The other half of the gain is taxable in the corporation.
The non-taxable portion of a capital gain may result in the application of the Alternative Minimum Tax (AMT) (see Section 5). This is more likely to apply when the capital gains exemption is used.
Some tax credits may be affected in the current year and/or the year after reporting a capital gain even though the capital gains exemption is used. This is because the taxable capital gain is reported on your tax return and affects the calculations of tax credits even though the exemption is used to reduce the tax paid. The increased net income may result in the claw back of some benefits such as the Old Age Security and Child Tax Benefits in the current year and may also reduce them in the year following the capital gain.
$1,000,000 Capital Gains Exemption5
In 2015, the Capital Gains Exemption was increased from $824,176 (up from $813,600 due to indexing) plus an additional exemption amount of $175,824 bringing the total Lifetime Capital Gains Exemption to $1,000,000 for dispositions occurring after April 20, 2015. The $1,000,000 Capital Gains Exemption is available to individuals on the sale of qualified farm property. An individual, who used the entire $100,000 general exemption when it was eliminated in 1994, has $900,000 remaining.
The exemption is also available to partners in a partnership, since capital gains in a partnership flow directly to the partners who then can utilize the exemption. The capital gains exemption is not available to corporations; however, the shares of a family farm corporation are eligible for the exemption.
Qualified farm property6 includes:
Equipment and machinery are not eligible for the capital gains exemption. However, in a partnership or corporation, the value of equipment and inventory is included in the corporate shares or partnership interest.
Qualified farm property must meet the following definitions:7
In all cases, the qualifying individuals, whether farming as a sole proprietorship, a partnership or corporation, must be actively engaged in management and/or the day-to-day activities of the business.
What Does "Principally Used" Mean?
From the previous section, it is clear the term "principally used" is an important factor in determining what qualified farm property is. The term unfortunately is not defined in the Income Tax Act, 1985. However, CRA has said that for administrative purposes, it means "more than 50%" - both from a time perspective and a usage point of view. For example if a farm building was used in farming for 10 years and rented for 8, it would meet the test. However, if during the time period, it was used 80% of the time in a non-farming-related business and only 20% in the farming business, it would likely not meet the 50% test.
1994 $100,000 Capital Gains Election
In 1994, the $100,000 capital gains exemption for general property was eliminated. At that time, individuals were allowed to make an election to increase the adjusted cost base of their property by up to $100,000, but not exceeding the February 1994 value. If you made such an election on your qualified farm property, you are deemed to have disposed of the property and reacquired it in 1994. The result is, you must now meet the more difficult post June 17, 1987 rules for qualified farm property on a future sale test.
Splitting Capital Gains Between Spouses
If both spouses contributed to the purchase of property, they can split the gains to reduce taxes. Although both may be on title, it is the contribution toward the purchase that is the most critical. Generally, the capital gains from assets that are transferred to a spouse by way of gift attribute back to the spouse who transferred the asset. However, the timing of the transfer is important.
Spouses added to title on or before December 31, 1971, would likely be able to split the capital gains. However, if they were added after that date, attribution rules would prevent splitting. The attribution rules do not apply on property that is sold to a spouse at fair market value. However, this must be a legitimate transaction with documentation and, where debt is involved, appropriate interest charged.
If the property is the asset of a spousal partnership, the capital gains will flow through to each partner based on their percentage ownership.
Using a Reserve to Defer Capital Gains
What is a Reserve?
A reserve allows for a deferral in reporting either business income or taxable capital gains. It is allowed when all or part of the proceeds of the sale are not payable until after the end of the year in which the property is sold. A reserve is also available for quota provided that an election under section 14(1.01) of the Income Tax Act, 1985 is made.
Usually a mortgage or a note is sufficient evidence that an amount remains outstanding. However, care should be taken when using a note. A promissory note without restrictions as to when payment can be demanded represents "absolute payment" of the debt and, in such a case, a reserve will not be allowed. The note should contain restrictions, such as payable 366 days after demand, to ensure that a reserve can be used.
A 5-year reserve is allowed on dispositions to unrelated parties. A minimum of at least 20% of the gain must be brought into income each year.
A 10-year reserve is allowed on the disposition of land, depreciable property or a share in a family farm corporation or an interest in a family farm partnership to a child. Accordingly, a minimum of 10% of the gain must be brought into income each year.8
A reserve is not available to an individual who transfers property to a corporation that he/she controls or did control or to a partnership in which the person holds a majority interest.9 A reserve is not available in the year of death.10
Why Use a Reserve?
There are several circumstances where a reserve might be useful. Firstly, if a large capital gain has been triggered, alternative minimum tax (AMT) may be payable even though the capital gains exemption is used. The use of a reserve could spread the gain over a number of years, reducing the possibility of paying AMT. As the capital gain is removed from the reserve, the capital gains exemption can be used.
The second circumstance is where the capital gains exemption is not available or has been fully used. Spreading the taxable capital gain over a number of taxation years may prevent income levels from reaching the higher tax brackets. It may also reduce the clawback of benefits and the possible application of the AMT.
How is it Calculated?
The amount available for a reserve is the lesser of two amounts (Table 2):
Replacement Property11 - Deferring Capital Gains
Capital gains and/or recapture can be deferred if replacement property is purchased. Replacement property is defined as "property acquired for the same or similar use."12 The interpretation of this requirement is quite broad. In the case of farm property, a replacement property would generally qualify if it fell into the category of farming.13 Also, the property must be used and not just acquired in order to qualify.
The length of time that you have to purchase the replacement property after disposing of the former property depends on the type of disposition. There are two types:
Where the disposition is voluntary, the property must be replaced within 12 months of the end of the taxation year in which the disposition took place. For example, if the taxation year-end was December 31 and property was sold in January 2015, it must be replaced by the end of December 2016.
Where the disposition is involuntary, the property must be replaced within 24 months of the end of the taxation year in which the disposition took place.
The deferral can be applied to land, buildings and quota in either type of disposition. However, if the disposition is involuntary, then the deferral is allowed on all depreciable property, including machinery and equipment.
In both cases, an election must be filed in the year the replacement property is purchased. Taxes on recapture or capital gains from the sale of the former property are paid in the year the original property is sold. When replacement property is purchased, a reassessment is done and a refund issued. Table 3 shows an example calculation.
Replacement property can be purchased before the former property is sold. There is no time restriction on the sale of the former property. However, the election must still be filed.
At one time, CRA did not allow the replacement property rules to apply where an expansion of the farm business had occurred (for example, where a 200-acre farm sold for a high value and was replaced with 500 acres of less expensive land). CRA, however, has relaxed its interpretation on this issue and while it depends on the facts of each case, it appears that purchasing more land than was sold will not prevent the deferral from being available.
The capital gain you would report would be the lesser of the following two calculations:
The actual capital gain
The amount by which the sale of the old property exceeds the cost of purchasing the replacement.
Here, $5,000 is reported as a capital gain. The difference of $200,000 ($205,000-$5,000) is deferred or rolled over. The ACB of the replacement property is reduced by the deferred amount, resulting in an ACB of $145,000 ($345,000-200,000).
While replacement property rules may not be used as much by individuals because of the $1,000,000 capital gains exemption, they are a useful tool for corporations, which do not have the capital gains exemption available to them.
A capital gain calculated using the replacement property rules can be offset by using a reserve.14
Principal Residence on the Farm15
Individuals are allowed an exemption on the capital gain of their principal residence. Farmers can use one of two options to calculate the gain on their principal residence.
The principal residence designation is limited to one per family unit, which usually includes spouses and children under 18 years old. Where a farm has two houses, the principal residence designation can only apply to one house at a time.
The exemption only applies to the personal portion of a residence. Farmers who use a portion of their home as a farm office can claim reasonable expenses for that portion used as an office, however, they should not claim capital cost allowance on the office portion since that could result in a loss of the principal residence exemption on the office portion of the house.16
Several other situations can arise on a farm.
Depreciation is an economic term that describes the reduction in value of an asset because of usage. The tax term is capital cost allowance (CCA) and is an amount assigned by the Income Tax Act, 1985. For tax purposes, there are two ways in which the capital cost allowance can be calculated. The straight-line method can be used on assets purchased before 1972 (called Part XVII assets) and the declining balance method is used on all assets purchased after 1971 (called Part XI assets).
Machinery, Equipment and Buildings Purchased After 1971 (Part XI Assets)
Part XI assets are grouped into classes, each of which has prescribed rates of capital cost allowance. The sum of all the additions, sales and deductions of CCA taken is called the undepreciated capital cost (UCC).
When depreciable capital property is sold, the lesser of either the sale price or the original cost of the asset is subtracted from the class.
A sale of an asset can result in recapture of capital cost allowance and/or capital gain, depending on the sale price.
Recapture of CCA occurs when the sale of the assets causes the UCC balance of the class to fall below zero (i.e., a negative balance is created in the class). In effect, this means that the assets have depreciated less than what has been claimed on your tax returns. Therefore, because you had previously claimed that amount as an expense, the difference must be "recaptured" and reported as income.
Capital gains can occur on buildings, machinery and equipment when their values have appreciated. The capital gain on buildings can be offset with the capital gains exemption, if available, however, machinery and equipment have no exemption for capital gains.
If you sell all the items in a class, you must keep track of the sale price of individual assets. This is because the proceeds must be allocated on an asset-by-asset basis in order to calculate the gain. To calculate the capital gain, you need to know the original cost of the items.
In Table 4, the UCC is reduced by $168,000, causing the balance to fall $18,000 below zero ($150,000 - 168,000 = -18,000. The $18,000 is then added to income, along with 50% of the capital gain.
The calculation is as follows:
Taxable income = recapture + 50% capital gain
= $18,000 + ($15,000 x .50)
= $18,000 + $7,500
If you did not have records of the original cost of assets, you could potentially report the entire proceeds from the sale as a reduction in your UCC. This would result in $33,000 ($18,000 + $15,000) of fully taxable recapture, instead of part capital gains and part recapture.
Machinery, Equipment and Buildings Purchased Before 1972 (Part XVII)
Assets purchased before 1972 do not incur recapture but can produce a capital gain. While most of this machinery will be worn out, some well-maintained buildings or specialized equipment may produce a capital gain. It is important to keep them out of Part XI to avoid recapture.
The tax rules for buying and selling quota are quite complex. If you are planning to sell a large portion of your quota holdings, be sure to review the tax implications with your accountant or tax advisor.
Depreciating (Amortizing) Quota and Your Cumulative Eligible Capital (CEC) Account
Quota is a type of property called Eligible Capital Property (ECP). Quota holdings are recorded in a special account called the Cumulative Eligible Capital account or CEC account. This CEC account keeps track of your quota additions, sales and the annual allowance or depreciation you take as an expense.
Three-quarters (75%) of a quota purchase is depreciable, at a rate of 7% annually. If you bought $100,000 of quota, $75,000 (75%) would be added to your cumulative eligible capital account, and depreciated at a rate of 7% per year, on a declining basis. The other quarter of your quota purchase is non-depreciable.
Although the term "depreciation" is most often used, "amortization" is the correct term to use when referring to eligible capital property. Many accountants now use this term in their financial statements.
The sale of quota can generate taxable income from two sources. The first is the recapture of depreciation taken. The second is the increase in value over the original purchase price. Often this is referred to as a capital gain, however technically this is not correct since only "capital property" can generate a "capital gain."
Recapture on quota sales is similar to that of buildings, machinery and equipment. Recapture occurs when the cumulative eligible capital account falls below zero. When this occurs, a portion of the sale is recapture and is added to your income. If the quota has appreciated, the increase in value would be income that may be eligible for the capital gains exemption.
The increase in the value of quota can be treated one of two ways. It can be called business income that is eligible for the capital gain exemption and as such is not subject to Alternate Minimum Tax (AMT). Alternatively, an election can be filed that deems the increase in the value of quota to be a capital gain similar to that on land or other non-depreciable capital property17. Filing this election can impact the sale of quota in three ways:
A calculation should be done to determine which method is the most advantageous.
When quota is sold, the following calculations take place:
Table 6 shows how the calculation is made.
In the example shown in Table 6, $20,000 of recapture is added to the farm income, plus the appropriate deemed taxable gain.
The $4,000 pre-1988 depreciation adjustment occurs because in 1988, the capital gains inclusion rate was raised from 50% to 75%. Eligible Capital Property accounts were adjusted by 50% to account for the change in the amount of quota that was now eligible to be depreciated.
Depreciation taken before 1988, however, was not recalculated, so an adjustment is required at the time of sale to reduce the deemed taxable capital gain by half the pre-1988 depreciation. This is depreciation that is allowed under the post-1988 rules. In this example, the depreciation taken before 1988 is $8,000, so the adjustment is $4,000, which is subtracted from the deemed capital gain.
Ownership and Taxation of Quota
The amount of tax on a quota sale depends on how the quota is owned. For more detailed information on partnerships and corporations, see OMAFRA Factsheets Farm Corporations and Farm Partnerships.
Ownership by individual or partnership
If the quota is sold by an individual or a partnership, the recaptured $20,000 is taxable income in the year the quota is sold and taxed at the personal rate of the individual. The deemed capital gain qualifies for the capital gains exemption, which can be used if available.
Ownership by corporation
If a corporation sells the quota, three-quarters of the proceeds are subject to tax calculations. The recapture and capital gain is business income in the hands of the corporation and is eligible for the small business tax rate. A large quota sale could push the corporation's net income above the small business corporate tax rate and into the higher corporate tax rate. A solution to that would be spreading the quota sale over a number of years, if practical. The total amount of tax paid is dependent on the subsequent distribution of the sale proceeds to the shareholders.
Alternative Minimum Tax19 (AMT) is a tax on dividends from Canadian corporations and capital gains. The AMT calculation is an alternative calculation of taxable income that includes the non-taxable part of the capital gain. The calculation shown in Table 7 uses the approach outlined in the Act, which includes a four-fifths (80%) downward adjustment of the capital gain followed by the deduction of the taxable capital gain. A simplified approach is to include 30% for the entire gain (30% x $500,000 = $150,000).
The AMT allows an exemption of $40,000, which means that the AMT has no effect until a gain of more than $133,333 is realized20. This amount can also be higher when the personal credits are used in the calculation. This alternative calculation is then compared to the regular tax calculation and, if it is higher, the additional amount is payable.
Any minimum tax paid can be carried forward up to 7 years, and used as a credit against any tax payable in those years.
Ontario also has an AMT, which is 33.67% of the basic federal tax calculated under the AMT calculation.
1The calculation for the alternative minimum tax adjusts the capital gain downward by multiplying the gain by 0.80. This is done because of the capital gain inclusion rate change from 75% to 50%.
2 To calculate the regular tax payable, the 2015 federal and provincial tax rates were used. Federal tax rates are 15% on the first $44,701, 22% on income between $44,701 and $89,401, 26% on income between $89,401 and $138,586 and 29% on income of $138,586 and over. To calculate the federal tax payable in the minimum tax calculation, the rate is a flat 15%. The Ontario provincial minimum tax rate is 33.67% of the federal minimum tax.
3 Only the basic personal tax credit of $11,327 and the CPP credit have been used in this approximate calculation of federal and provincial tax payable, for the sake of simplicity. The use of other credits would further reduce the tax payable.
1Income Tax Act, 1985, Subsection 28(1)
This Factsheet was originally written by Rob Gamble, BSc. (Agr), MTax, Finance and Business Structures Program Lead, OMAFRA, Guelph and updated by Dave McLeod, Business Finance Specialist, OMAFRA, Guelph.
Part of this paper was taken from information originally compiled by Ralph Winslade (retired) and Dave Rose (formerly with OMAFRA).
This publication is intended as general information and not as specific advice concerning individual situations.
Although it outlines some of the legal and tax considerations of transferring farm assets, it should not be considered as either an interpretation or complete coverage of the Income Tax Act, 1985 or the various laws affecting family transfers. The Government of Ontario assumes no responsibility towards persons using it as such.
All asset sales or transfers should be discussed with your accountant and lawyer before they are undertaken.
Additional information on related topics can be obtained from the business portion of the OMAFRA website at: ontario.ca/agbusiness.
For more information:
Toll Free: 1-877-424-1300