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The lure of profits on subdivided land may be enticing, but there are some things to consider before deciding how to spend your profits.
You know about the capital gains exemption and how it applies to qualified farmland, so you are excited that you can sell the property and have $750,000 per owner worth of the profit shielded from tax right? Not necessarily.
The exemption applies to capital property, not inventory. To understand the difference, think of a retail clothing store, the racks are in the store to assist in displaying and selling the clothes. The racks are not ordinarily sold by the store. In farming, the land is there for the use of the business, to raise product such as grain or livestock for sale, not to sell.
Once the intention of the business is to subdivide and sell the land for profit, the use has changed from capital to inventory. This change in use triggers a deemed disposition for tax purposes. In other words, you are treated as though you have just sold the land you held as capital property to yourself at fair market value, to now develop as inventory.
As expressed above, the change of use depends on intention. It is still possible to subdivide farmland and sell it as capital. The evidence of an intended change of use often coincides with the development of water mains, sewers, roads, or other such improvements. The timing for the intended change in use is generally the earlier date that you begin developing the land for sale, or the date you apply for subdivision of the land into lots for sale (provided you continue to develop it). Other factors may also be considered.
Any increase in the value of the land after this change in use date is now taxed as income from the sale of inventory, which does not qualify for the capital gains exemption. The sale of the inventory is taxed at a 50% greater rate than capital gains. Understandably, we would hope to “deem” a higher value at the change in use date to be capital gains. Equally, tax authorities will often scrutinize this timing and allocation for tax collection purposes.
The change in use rule does not immediately trigger tax to the land owner. This tax is deferred until the land is ultimately sold. This treatment is preferable, as often no cash is available to fund a large tax bill until the land is sold. At the date of eventual sale, the land owner will be taxed on the capital gains resulting from the change in use, and on the additional growth in land value after that date as profit from inventory.
Determining the date of the deemed change in use, and allocating the resulting gains and profits, often requires professional judgment. In addition, considerations should be given to GST consequences and land transfer taxes. For more information, please contact your local MNP Tax advisor.
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