RESERVES FOR CAPITAL GAINS
RESERVES FOR CAPITAL GAINS
If you sell a property and have a capital gain, it must be reported for tax purposes even if some of the proceeds are due after the year of sale. One-half of the gain is included in income as a taxable capital gain.
However, similar to the situation discussed in the preceding section, a reserve is allowed by Income Tax Act subparagraph 40(1)(a)(iii) where some or all of the proceeds are due after the year of sale. In the case of capital gains, the reserve in a taxation year is the lesser of:
gain on sale x proceeds due after year / total proceeds on sale (conceptually, this is the portion of the gain that hasn't yet been received); and
The following fraction amount, depending on the year:
Year 1 (year of sale): 4/5 of gain
Year 2: 3/5 of gain
Year 3: 2/5 of gain
Year 4: 1/5 of gain
Years 5 and future: No reserve
The reserve deducted in one year is added back the next year, and if still available, another reserve may be claimed in that year. Owing to the fraction amounts described above, no reserve is allowed after the fourth year, even if some proceeds are due after the fourth year. Put more simply, at least 20% of the gain must cumulatively be recognized each year for 5 years.
In Year 1, you sell shares in a corporation for $500,000, resulting in a $100,000 capital gain. You receive $50,000 of the proceeds in Year 1. Another $200,000 proceeds are due in Year 2, and the remaining $250,000 is due in Year 3.
Year 1: You will report a $100,000 capital gain. You can claim a reserve equal to the lesser of:
1) $100,000 x $450,000 / $500,000 = $90,000 [since 90% of the proceeds haven't been received, you could postpone up to 90% of the capital gain under this rule], and
2) 4/5 of $100,000 = $80,000 [20% of the gain must cumulatively be recognized by each year].
Therefore, you can claim a reserve of $80,000, resulting in a net capital gain in Year 1 of $20,000. One-half of that, or $10,000, will be included in your income as a taxable capital gain.
Year 2: You will report the $80,000 reserve claimed in Year 1. You can claim a reserve equal to the lesser of:
1) $100,000 x $250,000 / $500,000 = $50,000 [since half of the proceeds haven't been received, you can still postpone up to half of the $100,000 capital gain under this rule, and
2) 3/5 of $100,000 = $60,000 [since 40% of the $100,000 must now be recognized, as it's the second year].
Therefore, you can claim a reserve of $50,000, resulting in a net capital gain of $30,000. One-half of that, or $15,000, will be included in your income as a taxable capital gain.
Year 3: You will report the $50,000 reserve claimed in Year 2. No further reserve is available. One-half of the $50,000, or $25,000, will be included in your income as a taxable capital gain.
The total taxable capital gain will be $50,000 (one-half of the initial $100,000 gain), but it will be spread out over the three years.
The reserve is optional. All or any of the available reserve may be claimed in each year.