Taxation on the Sale of Farm Business Assets

Agdex#:	837
Publication Date:	02/03
Order#:	03-021
Last Reviewed:	02/03
History:	(Replaces OMAFRA Factsheet Taxation on the Sale of Farm Business Assets, Order No. 00-089)
Written by:	Rob W. Gamble - Finance and Business Structures, Program Lead/OMAFRA

Table of Contents

1. Section 1: Sale of Inventory Items
2. Section 2: Capital Gains
3. Section 3: Sale of Machinery, Equipment and Buildings
4. Section 4: Sale of Marketing Quota
5. Section 5: Alternative Minimum Tax (AMT)

This Factsheet provides information to farmers who are considering the sale of their farm assets. It applies to any sale at fair market value, regardless of whether the buyer is a stranger or a family member. For information on family transfers where the assets are being sold for less than their fair market value see OMAFRA Factsheet Taxation on the Transfer of Farm Business Assets to Family Members, Order No. 03-023 and Publication 70, Farm Estate Planning.

This information is intended for planning purposes only. It does not replace professional advice from a tax specialist.

Page 2 of the Factsheet is a summary chart outlining the tax implications of selling farm assets.

For other information on farm business structures see the following OMAFRA factsheets:

Farm Corporations, Order No. 01-057
Farm Partnerships, Order No. 02-047
Farm Business Joint Ventures, Order No. 02-069

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Section 1: The Sale Of Inventory Items

The sale of inventories such as crops, supplies and livestock are included in income just as other product sales are.

Inventory Sales - Tax Filed on a Cash Basis

• If it is a cash sale, the proceeds are included in income in the year payment is received.
• If the inventory is exchanged for an open account or note, the amount owed for the inventory is an account receivable and payments are included in income as they are received.

The following cash basis deductions from income may be available when inventory is sold.

• A basic herd deduction

• An optional inventory adjustment

The following is a summary of the tax implications of selling farm assets.

Asset:

Inventory - cash basis

Type of Income sale generates:

Farm income when payment received.

How it is Taxed:

Taxed at personal rate for sole proprietors.

Corporate rate for corporations.

When Taxed:

In the year payment is received

Options:

Spread payment over several years by note or open account.

Optional and mandatory inventory adjustments and basic herd deductions may be available.

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Asset:

Inventory - accrual basis

Type of Income sale generates:

Farm income when sold.

How it is Taxed:

Same as above

When Taxed:

In the year sold.

Options:

Beginning inventory is a deduction in year of sale.

Asset:

Machinery and equipment
(Part XI)
Post 1971

Type of Income sale generates:

Possibly recapture of capital cost allowance which is added to farm income.

Possible capital gains

How it is Taxed:

Recapture taxed at your personal rate.

50% of capital gains is added to income.

No exemption available.

When Taxed:

A reserve for recapture not available; recapture is added to income in year of sale.

Options:

Replacement property rules can be used to defer recapture, in some cases. Consider timing of machinery sale.

Consider deferring recapture by electing to move property from Classes 2 to 12 into Class 1 prior to sale.

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Asset:

Buildings
(Part XI)
Post 1971

Type of Income sale generates:

Possibly recapture which is added to farm income.

Possible capital gains.

How it is Taxed:

Recapture of CCA taxed at personal rate.

50% of capital gains is added to income.

$500,000 capital gains exemption can be used if available.

When Taxed:

Recapture is income in year of sale.

Options:

Capital losses can be deducted against capital gains.

If a capital gains reserve is created, the gain can be spread over a maximum of 5 yr., or 10 yr. if sale to family member.

Replacement property rules can be utilized.

Asset:

Part XVII
(pre 1972 assets)
Machinery, equipment and buildings

Type of Income sale generates:

No recapture.

Capital gains possible.

How it is Taxed:

50% of capital gains is added to income.

If available, $500,000 capital gains exemption used for buildings only.

When Taxed:

Recapture of CCA and capital gains are income in year of sale for machinery and equipment.

Options:

For capital gains on buildings a reserve could spread the gain over maximum of 5 yr. or 10 yr. in sale to a family member.

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Asset:

Land

Type of Income sale generates:

Capital gain

How it is Taxed:

50% of capital gains is added to income.

The $500,000 capital gains exemption can be used if available.

When Taxed:

Taxable in year of sale

Options:

A capital gains reserve can be used to spread the gain over a maximum of 5 yr. or 10 yr. In the case of a sale to a family member. Replacement property rules can allow for the deferral of capital gain.

Asset:

Quota (eligible capital property)

Type of Income sale generates:

Recapture of CCA

Quota can be taxed as a capital gain if an election is filed or as business income that is eligible for the capital gain exemption if no election is filed

How it is Taxed:

See calculation on Table 6.

When Taxed:

Taxable in year of sale

Options:

The $500,000 capital gains exemption can be used, if available, as long as quota is owned for at least a 24-month period.

Replacement property rules can be used to defer capital gains.

A reserve is available for quota if an election is filed.

AMT is payable on quota if an election is filed.

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Asset

House

Type of Income sale generates:

Capital gain

How it is Taxed:

Individuals are able to claim a principal residence exemption from capital gains

When Taxed:

Taxable in year of sale

Options:

Use the exemption or the optional method of reducing the total capital gain by $1000 plus $1000 per year of ownership for every year the house was the principal residence since 1971.

• A mandatory inventory adjustment
  
  In the year a cash loss occurs, you must decrease the loss by the amount of inventory purchased that year which is still on hand at year end. This is called the Mandatory Inventory Adjustment (MIA). 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, refer to line 9938 of your Statement of Farming Activities included with your previous year's income tax filing.

Inventory Sales - Tax Filed on an Accrual Basis

• The sale of inventory is considered income in the year sold, rather than when cash or payment is received. The beginning inventory is a deduction from income.
• If the beginning inventory's values are fairly current, the deduction should be large enough to minimize the tax consequences of sale of inventory.

A Cash Basis Example

Table 1 is a dairy farm example where the herd of cows plus young stock was sold for $120,000 and crops, feed and supplies for $45,000 with the appropriate deductions.

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Table 1. Cash Basis Inventory Sale

In this situation, the net income inclusion from the sale of cash basis inventory is $101,000. If the deductions were not available, the full sale of $165,000 would be added to income. The advantages of retaining a record of the basic herd and adding to the optional inventory in low taxable income years are obvious.

Section 2: Calculation of Capital Gains on Real Property

Payment of Income Tax

Payment of income tax on capital gains began January 1, 1972. 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 are sold for less than the undepreciated capital cost balance in that class, resulting in a terminal loss.

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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. For land, the cost base is adjusted by adding any non-depreciable capital improvements, such as a new orchard. Legal and realty fees are added to the adjusted cost base. The ACB of buildings would be increased by any capital improvements or additions, beyond just the normal maintenance and repair. An example of a capital gain calculation follows:

Table 2. Calculation Capital Gain

Taxation of Capital Gains

One half of a capital gain is subject to regular income tax. The other half may be subject to the alternative minimum tax (see section E). The taxable portion is added to other personal income in the year it occurs. Any allowable capital losses are first deducted against the taxable capital gains in that year.

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Personal Residence on the Farm

You have 2 ways to handle the sale of the farmhouse.

• The house and ½ hectare (ha) of land can be designated as your principal residence, which is then exempt from capital gains. More than ½ ha can be declared, but to qualify it must be shown to be necessary for the use and enjoyment of the property. A reasonable allocation of the sale price between the house and ½ ha, and the farmland, must be made.
  
  The principal residence designation is limited to one per family unit, which usually includes spouses and children under 18. Where a farm has 2 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. While farmers usually claim expenses for that portion used as an office, you should not claim capital cost allowance on the office portion. This could disqualify you for the principal residence exemption on the entire house.
• The second method allows you to deduct, from the total capital gain on the entire property (house and farmland), $1,000 plus a $1,000 for every year since 1971 that the house was the principal residence. Under this method an allocation of the capital gain on the house and ½ ha does not have to be made.

Several other situations can arise on a farm.

• A house owned by a corporation is not considered a personal residence; there is therefore no principal residence exemption on the gain.
• A partnership cannot have a personal residence; however, a partner's share of the gain on a personal residence is exempt.

$500,000 Capital Gains Exemption

The $500,000 Capital Gains Exemption is available to individuals on the sale of qualified farm property. An individual who used their entire $100,000 personal exemption, which was eliminated in 1994, has $400,000 remaining. The exemption is also available for partners in a partnership, since taxes are paid at the individual level. Corporations, however, do not have any exemption.

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Qualified farm property includes:

• farm land and buildings
• shares in a family farm corporation
• an interest in a family farm partnership
• quota (referred to as eligible capital property - see Section 4 on quota).

   

Equipment and machinery are not eligible for the $500,000 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.

Property must be used in farming by:

• the individual
• the spouse, child or parent of the individual
• or by a family farm partnership or corporation of the individual, spouse, child or parent and

  Property purchased prior to June 18, 1987:

• must be used in farming at the time of sale or
• have been used in farming for any 5 years during its ownership.

Property purchased after June 17, 1987:

• must be owned for 24 months prior to the sale and
• in at least 2 years, the gross farm income must exceed net income from other sources or the property was used by a family farm partnership or corporation in a 2 year period during which time the individual, spouse, child or parent was actively involved in the farming business.

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.

Capital gains income is taxed at the individual's tax rate. However effective October 18, 2000 only 50% of the gain is taxable. For example, a $500,000 capital gain would result in $250,000 of taxable capital gain (50% of 500,000). The use of the terms "capital gain" and "taxable capital gain" can be confusing. The capital gain is calculated as outlined on page 3 and refers to the total gain. The $500,000 capital gains exemption is applied to this gain. The "taxable" capital gain is what you report for income tax. That is, 50% of the capital gain. A $500,000 capital gain would result in $250,000 of taxable capital gain. Your $500,000 capital gain exemption would provide an exemption for the $250,000 of taxable capital gain.

The $250,000 that is not taxable would be considered for alternative minimum tax calculations. (Please refer to Alternative Minimum Tax in Section E.)

Some tax credits may be affected in the year you use your capital gain exemption. This is because capital gains are included in calculating your net income for income tax, which in turn affects the calculation of tax credits. The exemption is used just before calculating the taxable income. This increase in net income may also reduce Old Age Security and Child Tax benefits for one year following the capital gain.

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$100,000 Capital Gain Exemption

The $100,000 capital gain exemption was part of the $500,000 exemption. The 1994 budget eliminated the exemption, allowing an election to increase the adjusted cost base of property by up to $100,000, but not exceeding the February 1994 value. The 1992 budget eliminated the exemption for certain investment and recreational properties for gains that accrue after that date. If you elected to use the $100,000 exemption to increase your ACB, you are deemed to have disposed of the property in 1994 and you must meet the post June 1987 rules for qualified farm property on a future sale.

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.

If a second spouse was added to title by gift, the timing is important. Spouses added to title on or before December 31, 1971 appear to qualify. However, if they were added on or after January 1, 1972, attribution rules prevent splitting. Attribution is where the gain is attributed back to the original spouse who gifted the property to the other spouse. A sale to a spouse at full value should not attract the attribution rules on future gains, however a transaction must take place.

If the property is the asset of a spousal partnership, gains flow through to each partner based on their percentage ownership.

Detailed Breakdown of Farming Assets

Good records of historical costs, 1971 values, and subsequent acquisitions, along with a breakdown of the sale price, are essential. The vendor and purchaser, with the aid of their advisors, should agree to the breakdown of values in the purchase agreement.

Using a Reserve to Defer Capital Gains

What is a reserve?

A reserve is a term used to describe the mechanism allowed by Revenue Canada to defer the reporting of either business income or taxable capital gains. It can be used when all or part the proceeds of the sale are not payable until after the end of the year in which the property is sold. A recent change in legislation means that a reserve is now available for quota (reference section 14(1.01) of the Income Tax Act).

A reserve is not available where a promissory note, without restrictions as to when payment can be demanded, is used to represent the unpaid balance. In this case the note represents "absolute payment" of the debt. Where a note contains restrictions, such as payable 366 days after demand, a reserve is allowed. Mortgages also qualify.

A reserve for capital gains must bring into income at least 20% of the gain per year; a gain is usually spread over no more than 5 yr. The exception is the sale of family farm property to children, which requires only 10% of the gain to be brought into income, resulting in a maximum 10-yr. spread of the capital gain.

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Why use a reserve?

Although the $500,000 capital gains exemption is available, there are several reasons to use a reserve. The first is where a large capital gain occurs, triggering alternative minimum tax. Using a reserve spreads 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, where available, can be used.

The second is to spread out capital gain income where the exemption was not available or had been used.

How is it calculated?

To calculate the amount of reserve available, the lessor of 2 amounts is considered:

• 4/5 of the gain in the year of sale ( 3/5, 2/5, and 1/5 in years 2, 3 and 4)
• (Amount payable at the end of the year ÷ Proceeds of the sale) X capital gain

Table 3. Calculating a Reserve

The Income Tax Act allows for the deferral of some or all tax on property that has been disposed of and then replaced. There are 2 basic types of dispositions that qualify for this deferral:

• an involuntary disposition, which includes property stolen, lost, destroyed or expropriated
• a voluntary sale of farm property

The deferral applies to land, buildings and quota in both cases. In an involuntary disposition, all depreciable property is allowed, including machinery and equipment. Replacement property is defined as "property acquired for the same or similar use". The interpretation of this requirement is quite broad. In the case of farm property, a replacement would generally qualify if it fell into the category of farming. [Reference Interpretation Bulletin 259R3]

Until recently, replacement property rules did not apply where an expansion of the farm business occurred, such as a 200-acre farm that sold for a high value being replaced with 1,000 acres of less expensive land. CCRA however has relaxed it's interpretation on this issue. While it depends on the facts of each case it appears that purchasing a larger block of land than was sold is not automatically considered a business expansion.

For a voluntary sale, the property must be replaced by the end of the following tax year. For example, if the property sold in January 1999, it must be replaced by the end of December 2000.

Property that was involuntarily disposed of must be replaced within 2 years following the disposition.

In both cases, an election must be filed in the year the replacement property is purchased. Any taxes owing on recapture or capital gains from the sale of the first property must be paid. When replacement property is purchased, a reassessment is done and a refund issued.

Replacement property can be purchased before the old property is sold. There is no time restriction on the sale of the old property. However, the election must still be filed.

Table 4. Example of a Sale and Purchase of
Replacement Property

Property is Sold for:	$350,000
ACB	125,000
Selling costs	20,000
Capital Gain	205,000
Replacement Property	$325,000

The capital gain you would report would be the lessor of the following two calculations:

Calculation
The actual capital gain sale price	$350,000
minus ACB	125,000
minus selling costs	20,000
Capital gain	$205,000
OR
The amount by which the sale of the old property exceeds the cost of purchasing the replacement.
Sale Price	$350,000
minus selling costs of old property	20,000
minus replacement property cost	325,000
Gain on replacement property	$5,000

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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).

The $500,000 capital gain exemption means that replacement property rules are used less often by individuals, but are valuable to corporations.

Section 3: Sale of Depreciable Capital Property

Prior to 1972 farmers could choose between 2 methods of depreciation for calculating the capital cost allowance (CCA). The straight-line method (Part XVII assets) can be used on assets purchased before 1972, and the declining balance method (Part XI assets) on all assets purchased after 1971. Part XI assets are grouped into classes, each of which have prescribed rates of capital cost allowance.

Part XI Assets (post 1971 assets)

When depreciable capital property is sold, there is the potential of having to report recapture of capital cost allowance and/or capital gain.

Each class of assets has a figure that represents the remaining value, in terms of tax deprecation, that is left in those assets. This is called the undepreciated capital cost (UCC). Each time an asset is sold, the lesser of the original cost and the sale price, is subtracted from the UCC. Recapture of capital cost allowance (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). This means the assets have not depreciated as much as you claimed. Therefore the difference must be "recaptured" and reported as income.

Capital gains can occur on buildings, machinery and equipment. 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. See Table 5 below.

In Table 5, the UCC is reduced by $26,900, causing the balance to fall $8,900 below zero ($18,000-$26,900 = -$8,900). The $8,900 is then added to income, along with 50% of the capital gain. The calculation is as follows:

Taxable income = recapture + 50% capital gain

= $8,900 + ($2,100 x .50)
= $8,900 + $1,050
= $9,950

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 $11,000 ($8,900+$2,100) of fully taxable recapture, instead of part capital gains and part recapture.

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 Table 5. Sale of Class 10 Property Example

	Original Cost	Sale	Reduction of UCC in Class	UCC Balance Remaining	Capital Gain
Opening				$18,000
Tractor 1	$12,000	$14,000	$12,000	6,000	$2,000
Tractor 2	20,000	13,000	13,000	-7,000	0
Wagon 1	500	600	500	-7,500	100
Wagon 2	2,500	1,400	1,400	-8,900	0
Totals	$35,000	$29,000	$26,900	-$8,900	$2,100

Part XVII Depreciable Assets

These old assets owned before 1972 do not incur recapture, but might involve a capital gain. Most old farm machinery is worn out, with no capital gains. However, well maintained buildings and specialized equipment may be subject to a gain. It is important to keep them out of Part XI to avoid recapture.

Section 4: Sale of Marketing Quota

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.

Depreciating (Amortizing) Quota and Your Cumulative Eligible Capital (CEC) Account

The Canada Customs and Revenue Agency classifies quota as Eligible Capital Property and changes in quota holdings affect your Cumulative Eligible Capital Account or CEC Account. The CEC account is a bookkeeping record that is set up to determine the annual allowance and to keep track of the property that you buy and sell.

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Three quarters (75%) of a quota purchase is depreciable, at a rate of 7% annually. The other ¼ of your quota purchase is non-depreciable, and is set aside from tax calculations when the quota is sold. If you bought quota worth $100,000, $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.

Although the term depreciation is most often used, "amortization" is the more correct word when referring to eligible capital property. Many accountants now use this on their financial statements.

 Table 6. Cumulative Eligible Capital Account

Year 1
Purchase	$ 100,000
Depreciable amount added to CEC	$ 75,000
Depreciation expense for year 1	$ 5,250
Residual of CEC account	$ 69,750
Year 2
Depreciation expense for year 2	$4,882.50
Residual of CEC account	$64,867.50

 

Selling Quota

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. The principle of recapture on quota is similar to that of depreciable property. 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, and a portion is income that may be eligible for the capital gains deduction. When eligible capital property, such as quota experiences an increase in value over it's purchase price, it is called business income that is eligible for the capital gain exemption. This farming income is eligible for the $500,000 Capital Gains Exemption and is not subject to Alternate Minimum Tax (AMT). Recent amendments to the Income Tax Act (section 14(1.01) now allow an election to be filed that treats the increase in the value of eligible capital property or in this case quota, in a similar manner to a gain on land or buildings. Filing this election can impact the sale of quota in three ways:

• AMT may be payable
• A capital gains reserve can be created for proceeds of the sale that are not due for until a future year or fiscal period.
• Capital losses can be used to offset any capital gains on the quota