How do you structure a hobby farm in the most tax effective way?
Structure a Hobby Farm
With ‘hobby farm’ we mean a farm that is relatively small – less than 2,000 hectares – and relatively expensive, since within a 2-to 4 hour drive from Melbourne, Sydney or Brisbane.
A farm of that size in that location is unlikely to make an operating profit when you consider the cost of land. Hence the term ‘hobby farm’.
In this episode Andrew Henshaw of Velocity Legal in Melbourne will discuss with you how to structure this in the most tax effective way.
Here is what we learned but please listen in as Andrew explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
Structure a Hobby Farm
Let’s set the scene with an example.
Imagine you want to buy a farm to run some cattle as absentee owners for a second income. The land includes an old farm house where you will stay when working on the farm.
You are at the top marginal tax rate, while your spouse’s marginal tax rate is 0%.
And your spouse is the sole shareholder of a company that has substantial tax loss carry forwards from a failed previous venture.
Horses for Causes
No structure is perfect for every scenario. It is horses for causes. A focus on asset protection will require a different structure than a focus on tax reduction would require.
So in our example, let’s say that you aim to
1 – Negatively gear the land against your income;
2 – Achieve exemption from land tax;
3 – Use the company’s tax losses to offset farming profits,
4 – Minimise CGT when transferring the farm to your children;
5 – Achieve exemption from stamp duty at time of transfer.
How should you structure the farm to achieve all this? Here is how.
1 – Negative Gearing
Negative gearing means that you offset a loss against other income. To negatively gear the land, you need to do four things:
a – You need to own the land.
Whoever wants to negatively gear, must be on the title. Hence don’t buy the farm through a company or trust. You will lose some asset protection doing that, but that is the price for negative gearing.
b – Only own the land, but not the business
To negatively gear, the land must only earn passive income. Only a loss from passive income can be offset against other income. So keep the land ‘passive’ by only owning the land and not the business.
c – Run the farm through a separate entity
Run the farming business through a separate entity – preferably a company or trust – to keep it away from the land. If you have tax loss carryforwards in a company like your spouse does in the example above, run the farm through a trust who then distributes any farming profits to that company.
d – Lease out the land at market price
You can only negatively gear the land, if it earns an income. So lease the land to the farming business at market rates. Longterm leasing rates are lower than bank interest, so you still have a negative margin to negatively gear.
2 – Land Tax
To get an exemption for land tax as land used for primary production, it doesn’t matter who owns the land. It only matters how the land is used. So if the land is used for primary production, it is exempt from land tax.
Whether the farm house is covered by this exemption depends on the title. If the farm house is on one title with the rest of the farm, it is covered by the exemption, since just a small portion of the large parcel of land. If the farm house is on its own title, then it is not covered by the primary production exemption.
3 – Loss Carry Forwards
To use the loss carry forwards in a company, run the farm through a trust that then distributes to this ‘loss company’.
Companies don’t get a refund of franking credits. So a company can use franking credits for a tax offset, but it can’t claim a refund the way individuals and trusts can.
For that reason don’t run the farm through a subsidiary company held by the loss company. If you did, you would have the subsidiary company pay tax on the farming profits. But when those profits are then distributed to the loss company, the loss company can’t get a refund of the tax the subsidiary company paid since franking credits are not refundable.
4 – Succession To Next Generation
To qualify for the small business CGT concessions upon sale, you need to pass the normal rules to qualify. But if you used the land for farming for at least 7.5 years or half of the time, and the farm has a turnover of less than $2m at the time of sale (and the years before), you run a good chance of qualifying.
The small business CGT concessions are complex, so let’s just say for now that the fact that you own the land while the trust runs the farm business won’t be an issue as long as you or your associate (your spouse) control the trust.
5 – Stamp Duty
Right now there is little you can do about stamp duty. But later on when you sell to your children or other close family members, you might qualify for a stamp duty exemption (primary production) as long as you sell from and to individuals and not a company or trust. If a company or trust is involved, the rules differ from state to territory, so look at the fine print.
Transfer to SMSF
When the farm is paid off, you might consider transferring or selling the land or farm into your SMSF. However, you face the following hurdles.
a – You need to have enough funds within the SMSF. Otherwise the contribution thresholds of $125k per year will be the bottleneck.
b – You pay 15% contribution tax on any contributions.
c – You can run a business within an SMSF to earn funds for your retirement, so you could transfer the farming business, but expect increased scrutiny from the ATO.
d – Once you move to pension mode, you need to make minimum pension payments, that can go up to 14% of the balance. So unless you have sufficient liquid assets, your SMSF might be forced to sell the farm or if you can subdivide, sell parcels of land.
e – When you die after your spouse, your non-tax dependents (your adult children who don’t live with you) face super death tax, meaning about 15% on any taxable component left in the fund.
f – So make sure the farm and any sales proceeds have left your SMSF by the time you and your spouse are gone. Not always easy to pull off since hard to predict.
So you hold your farm in your name and negatively gear it against your salary. You run the farm through a trust that leases the land from you at commercial rates. The trust distributes its profits to a company. You are exempt from land tax and hopefully can sell claiming the small business CGT concessions. And if your children buy the farm, they might not even have to pay stamp duty.
So this is how you structure a hobby farm based on a very general scenario. The devil is in the detail. Different circumstances might require a different structure.
Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 26 April 2021