If you sell a capital property for more than your cost of the property, you will have a capital gain. More technically, if your “proceeds of disposition” exceed your “adjusted cost base” of the property plus any sales costs like commissions, you will have a capital gain. One-half of the capital gain is included in your income as a “taxable capital gain”.
Normally, you include in income the full taxable capital gain in the year in which the proceeds are received or receivable by you.
However, if some or all of the proceeds of disposition are due after the year of sale, you can normally claim a capital gain reserve, which effectively spreads out the inclusion over up to 5 years in which you receive the proceeds.
The maximum allowable reserve in a year is the lesser of two amounts.
The first amount is sometimes called the “reasonable portion” amount, because it is the portion of the capital gain that can reasonably relate to the proceeds of disposition that are due after the year. Typically, this amount is determined by multiplying the gain by the fraction equal to: proceeds due after year / total proceeds. (An example is provided below.)
The second amount is sometimes called the formula amount because it is subject to a specific numerical formula. Basically, the amount is a fraction multiplied by the gain. In the year of sale (year 1) the fraction is 4/5ths, and in subsequent years 2 through 4, assuming the reserve still applies, the fraction is 3/5ths, 2/5ths, and 1/5th, respectively.
Since the reserve is based on the lesser of the two amounts, a couple of things become apparent. Because of the first amount, the reserve is not available in a year if no further proceeds are due after that year. That obviously makes sense, since it means you will have received all of the proceeds by that year. Because of the second amount, which only allows a reserve up to year 4, you will have to recognize any remaining gain in year 5 even if some proceeds have not yet been received.
If you claim a reserve in one year, you must add that amount back into your income in the next year, at which point you may be able to claim a further reserve, subject to the above rules. (If you did not add back the reserve, that portion of the gain would never be reported, which explains the reason for the add-back.)
Example
In year 1, I sell some real estate (not my home) for $700,000. My adjusted cost base was $180,000 and I incur $20,000 in sales commissions. As a result, I have a capital gain of $500,000 ($700,000 minus $200,000).
I agree for the purchaser to pay me the $700,000 over seven years, at $100,000 per year.
Year 1:
In year 1, I can claim a reserve equal to the lesser of:
- $500,000 gain x ($600,000 proceeds due after year / $700,000 total proceeds) = $428,571; and
- $500,000 gain x 4/5 = $400,000
If I claim the full $400,000 reserve, I will have a capital gain of $100,000, half of which is a taxable capital gain of $50,000, and is included in my income in year 1 as a taxable capital gain.
Year 2:
I must add back the $400,000 reserve claimed in year 1 into year 2.
Then I can claim a reserve equal to the lesser of:
- $500,000 x ($500,000 / $700,000) = $357,143; and
- $500,000 x 3/5 = $300,000.
My net capital gain in year 2 will equal the $400,000 inclusion minus the $300,000 reserve, or $100,000. One half of that gain, again being $50,000, is again included in my income for year 2 as a taxable capital gain.
The process will continue through year 4, after which no further reserve would be available. Therefore, any gain not yet recognized by year 5 must be reported in that year even though some of the proceeds aren’t due until years 6 and 7.
Reserve optional
The reserve is optional. Although you would normally claim it, in some cases you might choose not to.
For example, if you had capital losses that could offset your capital gains in year 1, you might choose to report a larger capital gain in year 1 by claiming less than the maximum reserve.
As another example, if you expect to be in a higher tax bracket in later years, you might choose to trigger more of the gain in year 1 and forego the reserve.
Reserve not allowed for certain sales
You are not allowed to claim the reserve if the purchaser of the property is a corporation that is controlled by you immediately after the sale. Control for these purposes usually means ownership of more than 50% of the voting shares of the corporation, but it also includes “de facto” control, which means control “in fact” even if you own less than 50% of the voting shares.
If the vendor of the property is a corporation, the reserve is not allowed if the purchaser is a corporation controlled by the same person or group of persons that control the vendor. Also, the reserve is not allowed if the purchaser corporation controlled the vendor corporation.
In the case of a sale to a partnership, the reserve is not allowed if you are a “majority-interest partner” of the purchaser partnership. In general terms, you will be a majority-interest partner if you are entitled to more than 50% of the income or capital of the partnership.
Interest on future proceeds
If you, as vendor of a property, agree to the payment of the proceeds of disposition over two or more years, you may also be paid interest since the proceeds are being paid over time. If so, the interest that is received or receivable in each year is included in your income in that year, and is not affected by the capital gain reserve, which is a different issue.