Claim a Capital Gains Reserve and Defer Taxes

Capital gains on sales of property other than your principal residence can be a significant tax cost in the year of the sale.

Whenever you dispose of capital or other property, principal residence aside, you need to report a capital gain when the sale price is more than the purchase price. When the property’s value is high the capital gain can add a significant amount to your tax liability. However, with some tax planning you can either defer or reduce the amount of capital gains.

Where you have a capital gain on the sale of property, you may be able to defer part of the capital gain by claiming a reserve. You may claim a reserve in cases where you receive payment of capital property over several years. The reserve allows you to defer payment of taxes on capital gains until the full proceeds are received.

For example, you sell a capital property for $100,000 and the terms of the sale prescribe that the buyer will pay $20,000 initially and the remainder in equal instalments of $20,000 over the next four years. In this case you may be able to claim a reserve.

Generally you can claim the reserve on the disposition of capital property unless you:

• Were not a resident of Canada at the end of the tax year of the sale of at any time in the following year;
• Were exempt from paying tax at the end of the tax year or at any time in the following year;
• Sold the capital property to a corporation that you control in any way.

Calculating the Reserve

If you are eligible to claim a reserve, the general formula for calculating it is:

The total gain (in excess of cost) divided by the total proceeds of the disposition multiplied by the amount payable after the end of the year.

Using our example, and assuming the original cost of the property was $60,000, the reserve that can be claimed in the year of the sale is calculated as:

$40,000 (excess of original cost) divided by $100,000 (sale price) multiplied by $80,000 (amount payable in the following year, for a reserve of $32,000. [$40,000/$100.000 X $80,000 = $32,000.]

When you report the capital gain on your tax return, you calculate it as proceeds of disposition of capital or other property minus the cost of the property, which is the full $40,000. Then you deduct the reserve for the year.

The remaining amount is the portion of the capital gain that you need to report in the year you made the sale. The reserve is reported on the Form T2017, Summary of Reserves on Dispositions of Capital Property.

In the following year you will have to include the reserve in the calculation of capital gain for that year. That means you will have to include the $32,000 reserve when you calculate capital gains on the income tax return for the year after the sale. You will have to calculate a new reserve for that year.

20 Per Cent Rule

For capital and other assets disposed after November 12, 1981, reserves are permitted only for a limited number of years. The limitations are the following:

Sale of capital assets: Generally, the maximum period over which most reserves can be claimed is five years. However, the rules specify that in any year the reserve should be a lesser of the amount calculated using the general formula above and 20 per cent of the total capital gain in the year of disposition, 40 per cent of the capital gain in the following year and so on. As a result, in each year the reserve is claimed, the general calculation and the 20 per cent rule must be compared.

In other words, you do not have to claim the maximum reserve in a tax year. However, the amount you claim in a later year cannot be more than the amount you claimed for that property in the previous year.

Note: Transfers to your child of family farm property, family fishing property, and small business corporation shares, as well as gifts of non-qualifying securities have an identical rule with a 10 year period.

Sale of ordinary assets resulting in business income: If you disposed of an asset in the normal course of the business and it generates ordinary business income, the maximum period to claim the reserve is reduced to three years. In this case the reserve will be the prorated portion of the profit that is due in each of the three years.

Reserves that you can claim on disposition of capital property can be a useful tool in terms of tax planning. Tax deferral and reserves can be used to reduce the overall tax on a large capital gain transaction as individual tax rates increase with the amount of income earned. However, if the proceeds are deferred over a long period of time the taxes may be due before the money is received. Make sure you have enough money to pay the taxes.

If you sell a capital or other property for a capital gain, consult with your accountant about making sure that you are taking advantage of all the possible tax planning points.