Capital gains and your exemption

Capital gains and your exemption
by Perry Pellegrini - 4, 2008

As discussed in previous articles, a capital gain is realized when you sell a capital asset for more than you paid for it. Not all of these gains are eligible for the Capital Gains Exemption. In this article, we will review the exemption, what qualifies for it, how it is applied and other issues raised when it is used.

The Capital Gain Exemption was first introduced in 1984, and has gone through many changes over the years. The most recent change came in 2007, when it was increased from a lifetime limit of $500,000 to a new limit of $750,000 per individual. The exemption is available on the sale of qualified farm assets, or shares of a qualified small business corporation. We will focus on the farm assets. They include qualified farmland, marketing quotas, shares of a qualified farm corporation and an interest in a farm partnership.

Qualified farm land
For land acquired prior to June 18, 1987 you need to have owned the land for at least 5 years and you, your spouse, parent or child must have farmed it for at least 5 years. For land acquired after that date you must have owned it for at least 2 years, farmed it for those 2 years and during those 2 years, your gross revenue from farming must exceed all other sources of income.

The rules surrounding land talk about qualified "owners" and qualified "users", which can become very complex and difficult to follow, as land passes through generations. In particular, we find that land acquired after 1987 often requires us to explore historic "owners" and "users" to qualify land currently owned by someone who cannot pass the "gross revenue" test.

Marketing quotas
Marketing quotas include things such as dairy and chicken quotas. They are tracked by you as an "Eligible Capital Expenditure". The calculations for these items are unique, and have formulas that can become somewhat convoluted in a text article such as this. Suffice it so say, if you sell quotas for more than you have paid for them, you will generate a gain that is treated similar to a capital gain. The Income Tax Act has made specific provision for the sale of these assets to qualify for the capital gain exemption. You should of course ensure that you review your quota sale with your tax advisor.

Shares of a qualified farm corporation
If you are farming in a corporation, the asset you own is "shares" of the corporation. Assuming your farm corporation owns all of the assets, including land, all of the value of your farm is represented by those "shares". Typically, when you set up the corporation, you would have acquired those shares for virtually nothing; therefore their adjusted cost base (ACB) to you is very small. But, if they represent the value of all your farm assets, their fair market value (FMV) is quite high. If you sold them you would have a sizable capital gain, and would look to use your capital gain exemption on this sale, should the farm company qualify.

In order to qualify, during the past 2 years at least 50% of the assets of the company must have been used in the farm business and, at the time of sale, at least 90% of the assets must be actively used in the business. You must not have too much idle cash in the corporation! It is also important to note that farmland, which is rented out, does not qualify as a farm asset.

Interest in a farm partnership
Similar to a farm corporation, if you are farming in a partnership your "interest" in the partnership is considered a capital asset, and if sold by you, could produce a capital gain. In order to qualify this gain for the capital gain exemption the partnership must have existed for at least 24 months and you must have been actively engaged in it throughout that 24 month period.

Claiming the capital gain exemption
You may recall from our previous article that capital gains are not fully taxable. In fact, only one half of the gain is included in income. If, for example, you had a gain of $750,000 you would put $375,000 on your tax return as a "taxable capital gain."

The exemption itself is technically referred to as a "Capital Gain Deduction", and is allowed up to a max of $375,000. So, in the above example, you would claim a taxable capital gain of $375,000 and then an offsetting deduction of $375,000. The result is that none of the gain is taxable.

There has always been confusion around the Capital Gain Exemption vs. the Capital Gain Deduction. The Exemption is touted as being a $750,000 capital gain exemption, yet you are only allowed $375,000 as a deduction. The math for the exemption is a follows: $375,000 of capital gain deduction PLUS the $375,000 representing the 50% of the capital gain that isn't taxable anyway, equals $750,000 of overall capital gain that you don't have to pay tax on. Sound confusing? It is, and that is why you should ensure professional advice guides you through it.

Tips and traps
Even though your capital gain may be exempt, you must still file and claim it accordingly. This is because other calculations on your tax return may be impacted. Old Age Security and various tax credit entitlements are income tested based on "Net Income", which curiously enough is calculated on your return after the capital gain is added, but before the deduction is claimed. In other words you will potentially lose some or all of these entitlements when you claim a capital gain. Sorry folks, that is just the way it is.

Also, since "Net Income" is so high and tax payable comparatively low, it triggers "Alternative Minimum Tax" (AMT). This is a complex, alternate tax calculation that can be triggered by items such as the capital gain deduction. It is intended to ensure that it "looks" like people with high net incomes at least pay some minimum level of tax. This is a cash flow issue, since you will have to pay this tax in the year you have the gain, but it is refundable over the next seven years, providing you have tax to pay in those years.

Finally, keep in mind that the capital gain exemption is available on a per person basis, not on a per farm basis. This means that each spouse, or family member, has $750,000 available to them, so long as they each own qualified farm assets.

Replacement property
You may also be able to defer tax on gains not otherwise sheltered by the capital gains exemption. Replacement Property provisions in the Income Tax Act, allow you to defer capital gains on land, in instances where you have bought new land to replace that which you sold.

Generally speaking, the new land must have been bought with the intention of replacing the sold land, it must be used in the same business (farming) and the new purchase must have occurred in the previous year, same year or subsequent year of the land sale.

For retiring farmers, the "used in the same business" requirement may be difficult to satisfy, but for someone downsizing, it can provide relief for gains on land that does not qualify for the capital gains exemption, or where gains are in excess of the exemption amount.

The capital gain exemption is a huge tax saving opportunity, but using it can be riddled with complexities! It is very important that you obtain professional advice, and not assume how it would apply in your situation.

Perry is a senior partner with Pellegrini LeBlanc in Red Deer, AB, which focuses on farm sale and financial planning throughout Alberta.