General requirements
If you dispose of a capital property and acquire a replacement property within a set time period, you may be able to defer part or all of the capital gain that would otherwise be recognized on the disposition. Similarly, if the property is depreciable property, you can defer the recognition of any “recapture”, which is an amount in excess of the undepreciated capital cost of the property.
The time period for the acquisition of the replacement property depends on the type of disposition:
- For voluntary dispositions, you must normally acquire the replacement property within 12 months after the end of the taxation year in which the former property was disposed of;
- For involuntary dispositions, the replacement period is 24 months after the year of the disposition. An involuntary disposition includes a destruction or expropriation of the former property where you receive compensation, such as insurance proceeds or expropriation compensation from a government).
In general terms, a replacement property qualifies under the deferral rule if it is reasonable to conclude that the property was acquired to replace the former property and it is put to a use that is the same or similar to the use of the former property. Certain other criteria may apply.
For voluntary dispositions, the former property and replacement property must be real property (land, buildings) used in a business. For involuntary dispositions, any capital property can qualify, other than a share of a corporation.
The mechanics of the deferral
In general terms, if you use at least the amount of the proceeds of disposition from the former property to acquire the replacement property, there will be no capital gain from the former property. For every dollar of proceeds that you do not use to acquire the property, you will have a capital gain.
Any recapture on depreciable property will be deferred if you spend proceeds at least equal to the recapture amount on acquiring the replacement property.
The deferred gain will reduce your tax cost of the property. As a result, the gain may be realized when you ultimately dispose of the replacement property.
The deferral is elective. If you do not make the election in your tax return for the year in which the replacement property is acquired, there is no deferral, and the regular capital gains or recapture provisions will apply.
The election does not apply to capital losses.
Example of deferral
You bought a building that was destroyed by fire in 2015. It was used in your business. The adjusted cost base (ACB) of the building was $200,000 and its undepreciated capital cost or UCC (basically, the amount of the cost not yet depreciated for tax purposes) was $160,000.
You receive $250,000 of insurance proceeds for the building and use that amount to acquire a new replacement building within the 24-month period described above. Your initial capital gain for 2015 will be $50,000 ($250,000 insurance proceeds minus $200,000 ACB of the building) and your initial recapture for 2015 will be $40,000 (effectively, the difference between the ACB and UCC). You make the deferral election.
Results: Since you used the entire amount of the $250,000 insurance proceeds to acquire the replacement property, the $50,000 capital gain will be deferred and not recognized in 2015. Similarly, the $40,000 will not be recognized in 2015. Instead, the ACB and UCC of the replacement property will be reduced to $200,000 and $160,000, respectively.
If, instead, you only used $240,000 to acquire the replacement property, you could only defer $40,000 of the capital gain, meaning that $10,000 of the gain would be recognized in 2015, and you would include in income the taxable capital gain, being $5,000. In this case, the ACB of the replacement property would be $210,000.