Pasture Lease Agreements

Agdex#:	812
Publication Date:	10/03
Order#:	03-091
Last Reviewed:	10/03
History:	Original Factsheet
Written by:	Rob Gamble, Finance and Business Structures, Program Lead/OMAFRA

Table of Contents

1. Section 1 - The Basics of a Lease Agreement: Legal and Tax Issues
   1. Human Components of a Successful Lease
   2. Tax Implications of Land Leases
2. Section 2 - Pasture Lease Arrangements: Estimating a Rental Price
   1. Stocking Rates
   2. Market Rates
   3. Calculating a Rental Rate
   4. Negotiating the Rental Rate
   5. Share of Gain or Flexible Rental Rates
3. Appendix
4. Related Links

This Factsheet is one of a series on leasing agreements. The first in the series, Land Leasing Arrangements, Order No. 01-065 details the legal, tax and management considerations of leasing land. A lease form to aid in the development of a lease arrangement is available in the factsheet Pasture Lease, Order No. 03-089.

Leasing and renting land is a common practice in rural Ontario. The kind of rental arrangements for pasture varies 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 pasture lease agreements and assist them in making sound decisions.

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. Pasture leasing 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?

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. These include:

• a clear understanding of the terms of the lease agreement. Even though a verbal lease agreement is a valid contract it is exceedingly difficult to prove what the terms were in the event of a disagreement. A written lease provides both parties with a record of what they have agreed to

• clarifying expectations and responsibilities of both parties. Where a dispute arises it can prevent costly legal action by providing for alternatives to a court proceeding

• a valuable guide to heirs if the landlord or tenant should die

• documentation for tax purposes.

A written agreement is not a sign of distrust but rather an indication from both parties that they want a clear understanding of the agreement they are making.

Components of a Lease Agreement

A written lease can be as simple or detailed as the landlord and the tenant wish. Table 1 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 add clarity to the lease agreement and provide discussion points for the landlord and tenant as they formulate the lease agreement.

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Written Lease Agreements (Table 1. Summary of Required, Recommended and Optional Lease Items)

Required Items

Names and addresses of tenant and landlord

Description of property to be rented - includes the common legal description and specifies buildings or areas to be excluded.

Term and renewal of the lease - when does it start and how long does it last and the renewal of the lease if the parties wish to maintain the lease agreement for a period of years. The lease should state when and how such a renewal would take place.

Rent payable - what is the amount of rent, how is it calculated and when is it to be paid.

Recommended Items

Right of inspection and removal of livestock - the landlord has the right to enter the rented property and the tenant has the right to remove the livestock. Also deals with compensa

tion for the tenant and the incoming tenant rights.

Transfer of property - it is important that the landlord and tenant discuss their expectations in the event that the landlord sells the farm property to a new owner during the term of the lease.

Termination of the lease -the lease should clearly spell out how the lease can be terminated.

The use of the land - the lease should state how the tenant is going to use the land.

Environment matters - this clause addresses the issue of environmental policies and responsibilities.

Insurance - a clause regarding insurance would allow the landlord and tenant to identify who will be responsible for insurance coverage.

Rights to assign or sublet the lease - the written agreement should contain a clause that prevents or allows the tenant to sublet.

Optional Items

Arbitration of differences - an arbitration clause describes how disagreements that the tenant and landlord cannot resolve themselves, would be dealt with. The most common practice is the appointment of an arbitrator.

Production practices and management decisions - this clause deals with the issue of production and management decisions that the landlord wants carried out by the tenant. Some of those factors could include:

- stocking rates, size and type of animal

- use of manure, fertilizer and chemicals

Income support payments, subsidies and reimbursements - the written agreement should clearly specify who would receive government or marketing agency payments.

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.

Compensation for property damages - the party who has suffered the loss should receive any compensation that is payable.

Rights of first refusal - the landlord may be willing to include an option to the tenant to purchase the property by matching the offer the landlord receives from a third party to purchase the lands.

Option to purchase - the parties may wish to discuss and include an option that allows the tenant to purchase the leased lands.

Tax Implications of Land Leases

The tax implications of leasing are discussed in detail in OMAF Factsheet Leasing Arrangements, Order Number 01-065.

Loss of Rollover and $500,000 Capital Gains Exemption

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

• the ability to use a tax deferred rollover on the transfer of land to children (called a rollover)

• 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 lease, where a portion of the production is given to the landowner as payment for the land, 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 with some inconvenience, check 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 livestock weight gain, 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 GST 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 one acre of land surrounding it are 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 at www.farmbusreg.com.

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Section 2 - Pasture Lease Arrangements: Estimating a Rental Price

Although beef cattle examples are used in this Factsheet, the principles and worksheets outlined apply equally to grazing dairy cattle, sheep, goats, horses, and other roughage-consuming livestock. The values used in the various worksheets represent illustrations of the principles and should be adjusted for the individual situations of the landlord and tenant.

Stocking Rate

Determining an appropriate stocking rate of the pasture is very important to both the landlord and tenant. If a pasture rent is based on a per acre basis it gives an incentive to the livestock owner to stock heavily. The landlord, in turn, may desire light stocking rates so as to preserve the pasture. Likewise, pasture leased on a share of gain basis could also lead to overgrazing. Thus, it is in the interest of both parties to discuss the stocking rate issue and develop a lease agreement that achieves maximum economic returns to resources while maintaining the pasture stand and quality.

Market Rates

While both the landlord and tenant should consider their own costs and returns in establishing a rental rate, the market demand will ultimately influence the final rate. The market rate is the going price resulting from negotiations between landlords and livestock owners. Previous year's rates, livestock inventories, price, and weather conditions for the current year all influence the market price.

Valuing Location, Water, and Landlord Services

The value of water, location and landlord services are subjective. However, these items have some value to the livestock owner.

Location: The pasture location is important if the livestock owner is caring for the livestock. The total cost can be computed by estimating the number of trips per season then multiplying by the number of miles, then multiplying again by the cost per mile. The number of trips should consider checking the cattle for count, health, minerals, and water supply as well as hauling or driving the cattle to and from the pasture.

Water: Good quality water in proper locations improves gain. If the water supplies go dry in mid-season, provisions must be made for hauling water or removing the animals. The lease agreement should establish the party responsible for these costs.

Landlord services: Landlord services vary from mere rent collection to taking complete care of the livestock during the pasture season. In most cases, the value of such services is included in the rental rate.

Other factors: Pasture rental rates per acre should reflect productivity. Past stocking rates, weed growth, and moisture affect productivity (stocking rates or carrying capacity).

Calculating a Rental Rate

The landlord's cost and livestock owner's return are two methods that can be used to estimate the cost and returns of the landlord and tenant. These then become a starting point for the negotiation of a fair rental rate. This can be calculated on a per acre or a per head basis.

Landlord's Cost Basis

In this method, the major task is to establish fair values for the resources and annual use charges to determine the landlord's cost. The valuation process is outlined in Table 2.

Livestock Owner's Returns Basis

A budget format that can be used to determine the livestock owner's returns is outlined in Table 3.

As outlined in the example for a 650 pound beef, current interest cost on the average in-vestment value (usually one-half the total value) should be used. Utilization of one-half the total investment value assumes a zero salvage value.

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Note: Appendix 1 contains and explanation of the terms and calculations used in this table.

Negotiating the Rental Rate

In Table 2 and Table 3 the analysis shows the landlord would like to receive $51.55/acre (or $25.78 per head based on 2 animals per acre). The tenant could afford no more than $51.00/acre (or $25.50 per animal based on 2 animals per acre). At that rate per acre the tenant would only receive a return on their labour and management of $16.60 per head (Table 3, line E).

These figures would be the basis for negotiating the rental rate. The process of negotiation allows both the landlord and tenant to understand the other's point of view and to consider the contributions that each party is making and their costs. In general, the equitable pasture lease rate is usually somewhere between the landlord's and livestock owner's figures.

Share of Gain or Flexible Rental Rates

Share of Gain

The landlord and tenant are sometimes interested in developing a share arrangement where the risk is shared. Under this type of arrangement, each party's contributions are used as the basis for dividing income. As outlined in Table 2, contributions of the landlord include interest, maintenance costs and taxes on the land, as well as taxes, depreciation, interest, repairs and insurance on the investment in fences, buildings, ponds and handling facilities. Other contributions may include fertilizer and other inputs. Contributions of the livestock owner include interest on the livestock investment, operating expenses and management as outlined in Table 3.

The income to be divided is the value of the livestock gain the pasture produced. Sharing the gain in this manner requires the price and the weight of the animals be measured at the beginning and end of the pasture season. Table 4 illustrates one approach to calculating each party's share of the gain or loss. The net return per head is divided based on the percentage share of costs contributed (based on Table 2 and Table 3). This percentage could still be adjusted if the landlord and tenant wished to negotiate further.

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Flexible Rental Rates

Table 5 shows 2 examples of methods of calculating a flexible rental rate for pasture. The first method uses a base price and adjusts for the rate of gain of the animals. The second method uses a base price and adjusts according to the price of the animals.

Resources

Appendix 1 contains 2 blank worksheets that a landlord and a tenant can use to calculate their costs and returns.

Land Leasing Tools and Grass Stocker Worksheet -Excel computer files that contain all the worksheets in this factsheet and calculate the profit potential of grass stockers are located on the OMAF Web site. You can find this by typing "grass stocker worksheet " into the search field of on the OMAF home page.

Livestock Budgets - Excel computer worksheets as well as manual (paper and pencil version) partial budgets for several types of grazing livestock are located on the OMAF Web site. You find these by typing "Ontario enterprise budgets" into the search field on the OMAF home page.

Summary

Pasture rental arrangements provide the both the landlord and the tenant with the opportunity of utilizing their assets in the most effective way possible. Good communication and the development of a written lease allow each party to benefit from the arrangement.

This publication is intended as general information and not as specific advice concerning individual situations. It outlines some of the legal and tax considerations of leasing arrangements but it should not be considered as either an interpretation or complete coverage of the Income Tax Act or the law effecting land rental arrangements The Government of Ontario assumes no responsibility towards persons using it as such. All land rental arrangements should be discussed with your farm management advisor, accountant, or lawyer before they are signed.

Portions of this Factsheet were taken from the North Central Regional Extension Publication No.149 entitled Pasture Rental Arrangements for Your Farm, by Larry N. Langemeier, Professor, Kansas State University. The author would like to gratefully acknowledge his permission to do so.

The author would also like to thank Douglas C. Jack, Barrister and Solicitor, Fergus, Ontario for his assistance in the preparation of the sample lease agreement. The author would also like to thank Nancy Noecker, Beef Cow/Calf Specialist OMAF and Jack Kyle, Grazier Specialist, OMAF for their assistance in reviewing this factsheet.

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Other OMAFRA Business Factsheets

Business Stuctures Series

Farm Corporations, Order No. 01-057
Farm Partnerships, Order No. 02-047
Farm Business Joint Ventures, Order No.02-069
Forming a Cooperative, Order No. 02-019
New Generation Cooperatives, Order No. 02-017

Land Leasing Series

Crop Share Lease Agreements, Order No. 01-067
Flexible Cash Lease Agreements, Order No. 01-069
Land Lease Arrangements, Order No. 01-065
Lease Agreements for Cropland, Order No. 01-071

Farm Management and Taxation Series

Budgeting Farm Machinery Costs, Order No. 01-075
Canada Pension Plan, Order No. 01-029
Farm Business Insurance, Order No. 00-041
Field Crop Budgets (annual), Publication 60
Guide to Custom Farmwork and Short-Term Equipment Rental, Order No. 02-015
Leasing Farm Equipment, Order No. 01-003
Ontario Farm Record Book, Publication 540
Options for Farmers Dealing With Financial Difficulty, Order No. 04-041
Programs and Services for Ontario Farmers, Order No. 02-043
Taxation on the Transfer of Farm Business Assets to Family Members, Order No. 03-023
Troubleshooting Your Farm Business, Order No. 00-107

Appendix

Land: Land is valued at its current fair-market value for agricultural purposes. The influence of location near cities and other non-agricultural influences on value are ignored.

Interest on land: A percentage of the land value indicates the landlord's return to the current value and also reflects the pasture productivity. A practical "bargaining" rate of interest tends to be approximately 5-7% for 3 primary reasons:

• The current value of real estate is used rather than the purchase price for the basis of returns.
• Upon sale of the pasture, the net dollars available to the seller would be lower than the fair-market value due to income taxes and sale expenses.
• Historic returns to land have been in the 4-6% range as an annual return above all charges, except land.

Returns to owning pasture may include capital gains as well as the annual income from renting the pasture.

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Property taxes: Use the actual annual taxes.

Land development: Use the average dollars spent annually for land improvements, including conservation practices.

Building or facility investment: Assess a fair-market value on the fences, buildings, ponds, wells and handling facilities. Ownership costs on this investment include depreciation, interest, repairs, taxes and insurance (the "DIRTI five").

• Depreciation: Depreciation life for buildings and facilities usually ranges from 15-30 years. Fences from 10-15 years.
• Repairs, taxes, and insurance: Facility repairs usually vary from 1 to 3 percent of the investment value, with the charge for both taxes and insurance about 0.25 to 1 percent.

Other costs: The average spent annually for fertilizer, especially if some minimum level is required for maintaining the grass, as well as any other costs should be used.

Management: Management is an important contribution to a successful leasing agreement. The function of management may or may not be shared. If the landlord contributes management, then credit needs to be given. If the tenant bears all management responsibility, a value should be placed on this management function.

The value of management is subject to negotiation between the landlord and tenant. Two alternatives are possible.

• A possible guide is 1-2.5% of the average capital managed. The average capital managed is equal to the market value of items such as land, buildings and facilities, and livestock.
• Professional farm managers commonly charge 5-10% of adjusted gross receipts. (In the case of pasture, gross receipts may be equal to the total or per acre livestock income.)
  

Related Links

• Farmland Property Tax program
• OMAFRA Web site

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