The lifetime capital gains exemption (CGE), for qualified farm property, allows for significant tax savings when selling assets, and can be important for retirement planning, and preparing for farm transition. Although the CGE rules are quite technical, they're also very generous, particularly with farm real estate. With some smart planning, the CGE can save hundreds of thousands of dollars, especially if you can access multiple individual's CGE limits.
If you're thinking of selling assets, it's important to have a detailed discussion with your accountant about the rules and determine if your property qualifies as farm property for the CGE. A plan should consider all implications and opportunities. Below is an overview of four ways to multiply CGE.
1. Create a partnership
A simple technique to take advantage of multiple CGE's is a valid partnership, where the parties contribute their time and effort to the farm operation. For example, when the farm partnership sells real estate used in the farming operation, you can split the capital gain among the partners and each partner can use their CGE. The partnership must exist for a minimum of two years before the disposition. Many farm families across the country already operate in partnership, most commonly with spouses and children. While planning, be cautious of the income tax rule requiring allocations of income from the partnership be “reasonable” in relation to the capital invested or work performed.
Simple, quick fix solutions can be fraught with issues so proper planning, done well in advance, is essential to avoid problems. For example, a farmer operating as a sole proprietor and who owns land is thinking about retiring and selling the farm. The farmer wants to transfer the farm or part of it to a spouse to allow for access to another capital gains exemption. When a person transfers capital property to a spouse there's an automatic rollover at cost, which avoids triggering capital gain. However, when the farm is sold resulting in a capital gain, the “spousal attribution” rules require the spouse's share of the capital gain be reported on the farmer's tax return and not on the spouse's return. Transferring a personally owned farm to a partnership with a spouse does not necessarily avoid the spousal attribution rules. A better approach in some cases might be simply having a personally owned farm owned jointly from the initial date of purchase and used in the farm operation by a family farm partnership.
2. Transfer land to children
Another option might be to transfer all or partial ownership of farm real estate to your children to allow access to their CGE on eventual sale — basically multiplying the farm capital gain exemptions that can be claimed. Subject to certain conditions, farm real estate used in your farming business can be transferred to your children at its cost. Then the children could sell the farm and access their farm capital gains exemption. However, if there's a plan to sell the farm property, or an arrangement to sell the farm property, within three years after you transferred it to the children, the plan will not work as desired. The parent will be considered to have transferred the property to the children at the full fair market value. Furthermore, the parent has to report the full capital gain on their personal tax return in the year the farm was transferred to the children.
3. Create a corporation
Using a family farm corporation can also allow for income splitting and multiply access to the CGE. If properly structured, other family members such as a spouse and children can own shares of the family farm corporation. If they sell their shares for a gain, they would be able to use their capital gains exemption.
4. Use a trust
A family trust, established while you are alive and owning shares of a family farm corporation, is another common technique for multiplying access to the CGE. A properly structured trust will allow you to control the property owned by the trust, while at the same time the income and capital gain on the property will belong to the beneficiaries, which could include your spouse, children, and grandchildren.
For example, say you plan to transfer your farm operation to a corporation. One option would be to establish a family trust where you and your spouse could be the trustees (control the trust and trust property) and the beneficiaries include you, your spouse, and your three children. The common shares of your new family farm corporation are issued to the family trust. Common shares are the type of shares that grow in value.
After many years, the shares held by the trust have a significant capital gain, and exceeds $5 million. The shares are sold and the trust has a large capital gain. The trust then pays or makes legally payable the taxable portion of the capital gain (50% of the capital gain) to each beneficiary so we can use each beneficiary's $1,000,000 capital gains exemption. Approximately $5 million in capital gains has been sheltered from regular income tax. However, even with this plan other income tax consequences could result, such as alternative minimum tax, so make sure your accountant does a comprehensive review.
Another way to multiple the CGE is to have a family trust purchase and own the farm real estate used in your farm operation. If properly structured, when you sell the farm real estate the taxable capital gain can be allocated to the beneficiaries and they would be eligible to use their CGE.
Using partnerships, corporations, or trusts to multiply CGE has a myriad of other tax rules and implications that need to be considered, such as the “tax on split income” (known as TOSI in the tax world). For the plan to be successful, many technical details must be adhered to so proper tax advice from an experienced tax practitioner is a must. Reach out to Kurt Oelschlagel, BDO's National Agriculture Tax Leader to learn how we can help.