July 31, 2017 by Leanne Alexander

Using replacement property to defer capital gains on farmland

With replacement property rules, you can purchase farmland to replace a previous piece of farmland sold – as long as it’s used in the same (or a similar) business – and elect to defer any capital gain that might be incurred. Replacement might occur for the following reasons:

(a) farmers swap land with neighbours due to proximity to their farm business
(b) land is expropriated by government bodies and farmers find replacement land to continue their operations
(c) succession planning

The replacement property rules allow farmers the potential ability to elect not to incur any tax at the time of disposition, deferring this until a later date and time when the newly acquired property is disposed of. If you are thinking about taking advantage of this opportunity, it is a good idea to first get acquainted with the rules.

Does your new land qualify?

The greatest complications usually arise when farmers want to buy different property than what they have sold. Under the replacement property rules, it must be reasonable to conclude that the property was acquired to replace the former property in the same (or a similar) business. For example, if someone was using a piece of land for grain production, sold their land and replaced it with a property used as a campground, it would not qualify because this is a different business.

Timing of replacement

Another complication can arise due to timing. If you sell your farmland voluntarily, you only have 12 months after the fiscal year of the sale to buy and use the new property. If the sale is associated with an involuntary disposition – such as if a county or municipality decides to create a subdivision on land you are currently farming, essentially forcing sale and leaving you without the farmland required for your business – you have an additional 12 months to buy and use your new property while still qualifying under the replacement rules.

It is also worth noting that land obtained to replace sold land can actually be acquired prior to the sale in certain circumstances. If farmers aren’t aware that they must purchase and use the replacement property within a certain period of time, or perhaps are aware, but are not able to find new property, this can lead to a large tax bill that could have otherwise been avoided.

Replacement property utilized in succession planning

In recent years, we’ve seen an increased usage of replacement property in relation to succession planning strategies for farm families. As families try to pass farmland down to the next generation, some parcels of land might be held in their farm corporation and others might be held personally, which may not be ideal for what the farmer wants to achieve. In cases like this, you can swap land between yourself and the corporation without incurring some or all of the capital gain, allowing for more strategic succession planning and for farm families’ objectives to be better met.

Common mistakes and misconceptions about replacement property

The biggest myth about replacement property is that, in order to qualify at all, you have to spend the entire proceeds of your sale. However, a farmer can still qualify for the election if the requirements are met. This allows them to defer a portion of the capital gain, even if the entire proceeds from sale are not reinvested into the new property.

For example, say Farmer John sold a piece of land for $1,000,000, which originally cost him $500,000, and he found another piece of property that he purchased in the year to use in the same farm business for $750,000. Without the election, he would incur tax on a capital gain of $500,000, as that is the difference between his proceeds on disposition and the original adjusted cost base of the property sold. By filing the replacement property election, he believes that he will be deferring tax on three-quarters of the gain on sale (i.e. $375,000 gain deferral) since he is reinvesting three-quarters of his proceeds. However, in this scenario, he is only deferring half of the gain, as $250,000 was not reinvested in the new property and will be subject to tax on the remaining gain he was unable to defer. Farmer John will defer some tax and be able to replace his property to continue his farming business, but he will still be in a taxable scenario.

Leanne Alexander, CPA, CA, is a partner at Collins Barrow Red Deer LLP. Her industries of expertise include farming and agriculture, manufacturing and medical professionals.