Cash Lease Agreements For Cropland

Agdex#:	812
Publication Date:	October 2001
Order#:	01-071
Last Reviewed:	August 2008
History:	This Factsheet is one of a series on leasing agreements. The first Factsheet Land Lease Arrangements, Order No. 01-065 details the legal, tax and management considerations of leasing land.
Written by:	R. W. Gamble - Finance and Business Structures Program Lead/OMAFRA)

Table of Contents

• Section 1 — The Basics Of A Lease Agreement: Legal And Tax Issues
  • Summary of Required, Recommended and Optional Lease Items
    Written Lease Agreements
• Section 2 — Developing A Cash Lease Arrangement
  • Advantages and Disadvantages of Cash Leases for Landlord
  • Advantages and Disadvantages of Cash Leases for Tenant
  • Table 1. Landlord Ownership Costs Worksheet
  • Table 2. Tenant's Net Return to Land Approach
  • Table 3. Comparison of Methods
• Section 3 — Lease Checklist And Worksheets
  • Table 4. Farmland Lease Checklist
  • Table 5. Blank Ownership Costs Worksheet
  • Table 6. Blank Tenant Net Cost Worksheet
• Resources
• Appendix A — Sample Cash Lease Agreement For Cropland
  • Section 1 — Required Items
  • Section 2 — Recommended Items
  • Section 3 — Optional Items

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Leasing and renting land is a common practice in rural Ontario. The types of rental arrangements for cropland vary widely throughout the province, as do the relationships between landlords and tenants. What is desirable or fair for one particular landlord–tenant relationship is not acceptable for others. The purpose of this Factsheet is to help tenants and landlords develop fair crop share lease agreements and assist them in making sound decisions. A sample cash lease can be found in Appendix A.

Section 1 — The Basics Of A Lease Agreement: Legal And Tax Issues

Human Components of a Successful Lease

Any form of business agreement requires a good deal of mutual respect and trust. Leasing land is no different. To be successful the lease arrangement must satisfy both the landlord and the tenant. Before entering into a lease the landlord and the tenant should consider more than just price. The compatibility of the landlord and the tenant and the fairness of the lease should be considered. The following is a list of characteristics commonly found in successful lease agreements:

• Compatibility — Can you get along and discuss differences?
• Honesty — Do you trust the person you’re dealing with?
• Clarity — Do you both know what the terms of the lease are and is in writing?
• Equitable Terms — Are the terms fair to each party?
• Flexibility — Can you adjust the lease if changes occur?
• Suitability — Does the lease fit the crop and encourage good agricultural practices?

Is A Cash Lease The Best Arrangement For You?

The high capital cost of land makes leasing an attractive alternative to ownership. There are advantages and disadvantages to leasing farmland to consider before entering into a leasing agreement. Advantages and Disadvantages of Cash Leases for Landlords and Advantages and Disadvantages of Cash Leases for Tenant lists the advantages and disadvantages of a cash lease arrangement.

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Advantages Of A Written Agreement

While the majority of farm lease agreements are verbal in nature, there are advantages to putting an agreement in writing.

1. The greatest benefit is a clear understanding of the terms of the lease agreement. Even though a verbal lease agreement is a valid form of contract, it is exceedingly difficult to prove what the terms are in the event of a disagreement. A written lease provides both the landlord and the tenant with a record of what they have agreed to.
   
   
2. It makes the expectations and responsibilities of both parties clear and, if a dispute arises it can prevent costly legal action by providing for alternatives to a court proceeding.
   
   
3. It provides a valuable guide to heirs if the landlord or tenant should die.
   
   
4. It provides documentation for tax purposes.
   
   
5. A written agreement is not a sign of distrust, but rather a desire of both parties to have a clear understanding of the agreement they are making.

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Summary of Required, Recommended and Optional Lease Items

Written Lease Agreements

Required Items

Names and Addresses of Tenant and Landlord

Recommended Items

Right of Inspection and Removal of Crops — landlord has the right to enter the rented property, the tenant has the right remove the crops. Also deals with compensation for the tenant and the incoming tenant rights

Optional Items

Resolving Differences — an arbitration clause describes how disagreements that the tenant and landlord cannot resolve themselves, would be dealt with. The most common practice is appointing an arbitrator

Required Items

Description of Property to Be Rented — includes common legal description and specifies buildings or areas to be excluded

Recommended Items

Transfer of Property — landlord and tenant should discuss their expectations if/when the landlord sells the farm property to a new owner during the term of the lease

Optional Items

Production Practices and Management Decisions — decisions the landlord wants carried out by the tenant. For example:

• cropping decisions
• use of manure, fertilizer and chemicals
• crop and revenue insurance
• delivery and sale of crop

Required Items

Term and Renewal of the Lease — when it starts, how long it lasts and, when and how the lease can be renewed

Recommended Items

Termination of the Lease — clause that clearly spells out how the lease can be terminated

Optional Items

Income Support Payments, Subsidies and Reimbursements — a clause clearly specifying who will receive government or marketing agency payments

Required Items

Rent Payable — how much, how it is calculated and when it is to be paid

Recommended Items

The Use of the Land — clause that states how the tenant is going to use the land

Optional Items

Compensation for Repairs to Buildings, Fences, and Improvements — who is responsible for repairing buildings, fences, and other improvements, and how the expenses will be shared

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Recommended Items

Environment Matters — clause addressing issue of environmental policies and responsibilities

Optional Items

Compensation for Property Damages — the party who has suffered the loss should receive any compensation payable

Recommended Items

Insurance — clause allows landlord and tenant to identify who will be responsible for insurance coverage

Optional Items

Rights of First Refusal — the landlord may include an option for the tenant to purchase the property by matching the offer the landlord receives from a third party

Recommended Items

Rights to Assign or Sublet the Lease — a clause that prevents the tenant from subletting

Optional Items

Option to Purchase — a clause giving the tenant the option to purchase the leased lands

Optional Items

Municipal Zoning Restrictions — the tenant enters into a farm lease with the express intention of conducting agricultural operations; thus, it is important that the landlord provide an assurance to the tenant that the lands are properly zoned for such use

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The Components Of A Lease Agreement

A written lease can be as simple or detailed as the landlord and the tenant wish. The Summary of Required, Recommended and Optional Lease Items - Written Lease Agreements and the following section summarize the information to consider in drawing up a lease agreement. These are categorized under 3 headings:

• Required — all leases must contain this information
• Recommended — items that every landlord and tenant should consider including in the lease agreement
• Optional — items that add clarity to the lease agreement and provide discussion points for the landlord and tenant as they formulate the lease agreement.

Tax Implications Of Land Leases

The tax implications of leasing are discussed in detail in the OMAFRA Factsheet Land Lease Arrangements, Order No. 01-065.

Loss of Rollover and $500,000 Capital Gains Exemption

Landlords can inadvertently disqualify themselves from being able to use the following 2 major tax provisions.

1. The ability to use a tax deferred rollover on the transfer of land to children (called a rollover)
2. The $500,000 capital gains exemption on their land.

This can happen because Canada Customs and Revenue Agency (CCRA) do not consider many types of leasing arrangements farming. Even a share crop lease, where a percentage of the crop is given to the landowner as payment for the land rent, does not meet their definition. As a result some leasing arrangements can cause a landowner to lose their farming status and the ability to use the tax provisions. While these cases are not widespread and can often be remedied, consult with your accountant on how a lease might affect your individual situation.

Goods and Service Tax (GST)

Rent, which is paid by way of share of the crop, is not subject to the goods and service tax. The treatment of cash rents for GST purposes depend on whether the landlord is registered with Canada Customs and Revenue Agency to collect and remit the GST. If a landlord is not registered they are not required to charge the tax on the rent. If the landlord is registered, then the GST must be charged on cash rentals. The tenant is able to claim an Input Tax Credit on the tax paid.

Farmland Property Tax Program

The Farmland Property Tax program enables eligible farm properties to be taxed at 25% of the municipal residential/farm tax rate. The farm residence, and 1 acre of land surrounding it, is taxed as part of the residential class. To be eligible for the reduced rate a property must be part of a farming business with gross farm income of $7,000 or more, and must have applied for and received a valid farm business registration number. A landlord who is not registered can still obtain the reduced tax rate if the tenant has a valid farm business registration number. For further information contact AGRICORP toll free at 1-866-327-3678 or visit the Web site at www.farmbusreg.com.

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Section 2 — Developing A Cash Lease Arrangement

There are both advantages and disadvantages to cash rent arrangements. Landlords and tenants should consider the arguments outlined in Advantages and Disadvantages of Cash Leases for Landlord and Advantages and Disadvantages of Cash Leases for Tenant .

Advantages and Disadvantages of Cash Leases for Landlord

Advantages

Fixed cash rent relieves concern over variations in prices and yields. Price, cost and production risks borne by tenant.

Disadvantages

When substantial increases in commodity prices occur unexpectedly, landowner fails to share profits from higher prices.

Advantages

No concern with marketing of crops.

Disadvantages

Once a fixed cash rent is set, it may be difficult to negotiate changes as yields and costs increase over time.

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Advantages

Requires less managerial input than other kinds of leasing arrangements.

Disadvantages

Rental income is not considered farming income. If maintaining farming status is important consider different arrangement.

Advantages

Because of reduced involvement in management, reduced friction between owner and tenant on management decisions.

Disadvantages

Less opportunity to reduce tax by timing income (by holding crops or incurring expenses) in cash rental vs. crop share.

Advantages

Reduces concern about tenant recording accurate crop yield information.

Disadvantages

May be increased danger tenant will "mine" the land. Competition for land and appropriate requirements in a written lease can minimize this problem.

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Advantages

Straightforward method of payment.

Disadvantages

Tenant may not pay all of cash rent (for various reasons) or may be slow in paying rent.

Disadvantages

Income received from a crop share agreement is eligible for NISA; cash rent is not eligible.

Advantages and Disadvantages of Cash Leases for Tenant

Advantages

Allows tenant to make a larger profit if an unexpected increase in crop prices occurs or unusually favourable growing season results in higher yields.

Disadvantages

Cash rental rates tend to be negotiated based on last year’s market prices. Following good years this optimistic outlook can result in rents higher than justified.

Advantages

Less record keeping and time spent on dividing crops or income from sale of crops.

Disadvantages

Tenant bears all the yield and price risk. This is a greater concern if the land is not ideal or the crop is more variable in that location.

Advantages

Tenant has a relatively free hand in management decisions.

Disadvantages

Cash rent becomes a fixed cash expense, which may be very difficult to pay in a poor crop year or with abnormally low crop prices.

Advantages

Less likelihood of friction between tenant and landowner over management of crop.

Disadvantages

Cash rental rates tend to trend upward as crop yields increase, even though most of the yield increases may be a result of managerial skills. Rental rates don’t immediately decline with decreases in crop yields or prices.

Disadvantages

Landlord may be less willing to share land improvement costs. In a crop share agreement the increased productivity would increase their return.

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Establishing A Rental Rate

Most rental rates are established by using local market rates that reflect the supply of and demand for rental land in a local area.

In turn, crop share and flexible agreements use the market rate as the basis for establishing the crop shares or flexing provisions in the agreement. In the case of crop shares a traditional 1/3 – 2/3 or 1/4 – 3/4 split is common.

If the decision is to rent for cash, how is a fair rental rate determined? There are 3 approaches that can be used to establish a fixed cash rent for a particular farm or field:

• Current Market Approach
• Landlord’s Cost Approach
• Tenant’s Net Return Approach

A fourth approach not detailed in this Factsheet is to calculate the amount on a crop share basis and then adjust it to a cash rent basis. The adjustment takes into account the lower risk to the landlord that a cash rental carries. For information on calculating a crop share see the Factsheet Crop Share Lease Agreements, Order No. 01-067.

Current Market Approach

This method requires knowledge of cash rents being paid for farms in the area. Make adjustments for differences in the productivity of the farm, and the amount and quality of improvements. There are many factors that affect the rental price of land. Some of them are:

• Crop Prices — Rental rates often reflect the price of the crop being grown, but lag behind the down turns in the market price for that crop.
  
  
• Local supply and demand — Land that is close to farmers who want to rent land, particularly livestock and specialty operations, will be in greater demand.
  
  
• Drainage — Well drained, early land that is able to grow a high yielding crop is worth more.
  
  
• Fertility, compaction, erosion, heat units, and weed control — Fields that are relatively weed free and do not exhibit any signs of compaction, erosion or fertility deficiencies are worth more. Land in an area with higher heat units has greater potential yield.
  
  
• Small, irregularly shaped parcels with poor access for large machinery are worth less.

Other factors are also important to many landowners, who might take less rent than could be obtained from the highest bidder because of them.

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• Farmland Property Tax Program — Landowners that lease to a registered farm business are eligible for the Farmland Property Tax Program. Eligible farmland is taxed at 25% of the residential tax rate. This is a significant benefit to the landowner.
  
  
• Good Land Stewardship — Tenants that apply good land stewardship and care for the property are preferred over those that do not.
  
  
• Punctual payment — tenants that pay on time are preferred.
  
  
• Long term leases — mean that the tenant has a greater incentive to keep the land in top condition. Long term leases encourage good land stewardship.

The cash market approach has some disadvantages. It may be difficult to determine actual cash rents being paid for comparable farms and estimate what the rental rate adjustments should be. Despite these difficulties the prevailing market rates cannot be ignored. Even if other approaches for calculating the cash rent produce reasonable figures the local market will have the most influence in the negotiating process.

Landlord’s Cost Method

Under this approach, the landlord calculates the cost of land ownership to determine what rent is desirable. Landlords however will seldom receive enough cash rent to cover total ownership costs. Consequently, this method may result in an higher value than can be supported by production or local market prices. It does however give the landlord a basis for setting the "asking price" in cash-rent negotiations. Table 1 shows an example of this approach.

Some points to remember in calculating the ownership costs are:

Land — Land is valued at its current fair-market value for agricultural purposes. The influence of cities and other nonagricultural factors on land value is ignored. The value of land may include the value of such assets as buildings, improvements, and irrigation equipment if those items are also being rented.

Interest on land — A practical "bargaining" rate of interest can be set at the 4%–6% range.

Property Taxes — Use actual property taxes paid on land.

Land Improvements — Use the average dollars spent annually for lime, conservation practices, and other land improvements.

Table 1. Landlord Ownership Costs Worksheet

1. The rate of interest or return does not take into account capital gains and therefore would be lower than other investment rates of return.
2. Years of life will vary for buildings, fences, and different types of irrigation equipment.
3. Do not compute an interest charge if value of buildings, improvements, and certain irrigation equipment are included in value of land.
4. Do not include taxes on buildings, improvements, and certain irrigation equipment if taxes on these assets are included in property taxes calculated on land.

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Buildings and Equipment — Only include these if they are being rented as part of the package. Use depreciation, interest, repairs, taxes, and insurance charges on buildings and equipment. Estimate the average useful life of buildings and equipment as the basis for determining annual depreciation charge. The interest charge is on one half the investment value. Use actual annual repair, insurance, and taxes if known; or use a percentage of investment value. Note: Do not include taxes if already included in real estate.

Other — If capital has been invested to improve land productivity, such as drainage, then include a reasonable depreciation allowance for this investment. Tile lines are depreciable as Class 8 depreciable property, which is at 20% per year on a declining balance.

Tenant’s Net Return to Land Approach

Competition for land in some areas may see tenants bid more for land than they can actually afford. Tenants must calculate how much money will actually be available to pay for the use of land after variable expenses, fixed costs on machinery, and a return to labour and management have been deducted from the gross value of crops. Table 2 outlines a method to estimate how much can be paid for land in the form of cash rent. Table 5 is a blank worksheet for entering your own numbers.

The values for labour and management may be the most difficult to determine. The labour value used should reflect the amount of time used only for crop production and general farm maintenance. The hourly rate should equal what could be earned if working for other farmers in the area. Management is sometimes valued at 5%–10% of gross value of crops, or 1.5%–2.5% of the investment in land, equipment, and machinery.

Table 2. Tenant’s Net Return to Land Approach

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The Negotiating Process

Both the tenant and landlord can negotiate a final cash rental payment after considering all 3 methods. Table 3 summarizes the example values derived from the different methods. Both parties need to recognize that pressing an advantage too far can result in an unfair arrangement for one or the other. A lease that is unfair to either party is unlikely to last. An unfair, lopsided arrangement tends to encourage dishonesty and poor co-operation from the disadvantaged party. Over time, changes may occur, and "the shoe may be on the other foot".

Table 3. Comparison of Methods

Timing Of Rent Payments

Both tenants and landlords should consider the timing of rent payments. Several possibilities exist.

The landlord's chief concern may be that he actually gets full payment. But some landlords would prefer not to receive the entire rent payment at one time. Tenants can encounter cash flow problems if the rent is due in a single payment particularly if it is timed when no crops or livestock are ready for sale.

Some landowners require that a portion of the rent be paid at the beginning of the crop year with the remainder to be paid when the main crop or crops are harvested. If a single payment is used, it probably should be due at harvest time. But regardless of the number of rent payments agreed to, it is reasonable to schedule the payments to coincide with probable major sales of crops.

Section 3 — Lease Checklist And Worksheets

Table 4. Farmland Lease Checklist

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Table 5. Blank Ownership Costs Worksheet

1. The rate of interest or return does not take into account capital gains and therefore would be lower than other investment rates of return.
2. Years of life will vary for buildings, fences, and different types of irrigation equipment.
3. Do not compute an interest charge if value of buildings, improvements, and certain irrigation equipment are included in value of land.
4. Do not include taxes on buildings, improvements, and certain irrigation equipment if taxes on these assets are included in property taxes calculated on land.