If you sell capital property, or you sell inventory in the course of your business, and part or all of the sale price is due after year-end, you may be able to claim a reserve to defer recognizing some of the resulting capital gain or profit.
Capital gains reserve
This reserve can apply where you sell property and realize a capital gain. The maximum reserve you can claim in one year is limited to the lower of the following amounts:
- The portion of the gain equal to gain x (proceeds due after year / total proceeds) (i.e., you allocate the gain proportionately to the percentage of the sale price you have not yet received); and
- In year of sale ⅘ of the gain, in the next year ⅗ of the gain, in the next year ⅖ of the gain, in the next year ⅕ of the gain, and in the 4th year following the year of sale, nil. (In other words, you must recognize at least 20% of the gain every year, even if more than that percentage of the sale price has not been received.)
Because of the second limitation, the gain cannot be spread out more than 5 years including the year of sale.
Whatever you claim in one year is added back into your capital gains in the next year, and the calculation for the reserve is performed again in that year (if any).
In year 1 you sell some land and realize a capital gain of $100,000. You receive ⅓ of the proceeds up front, while ⅓ of the proceeds are due in each of year 2 and 3.
In year 1, you can deduct a maximum reserve equal to the lesser of: 1) $100,000 x ⅔ = $66,667 (two-thirds of the gain, since two-thirds of the sale price is still owing), and 2) $100,000 x ⅘ = $80,000 (four-fifths of the gain). So the most you can claim is $66,667. Assuming you claim the reserve, you have a net gain in year 1 of $33,333 and a taxable capital gain of half of that or $16,667.
In year 2, you add back $66,667 as a gain, but can claim another reserve of $33,333 in that year, resulting in another $33,334 capital gain and a $16,667 taxable capital gain. In year 3 there is no further reserve, so you will include the remaining $16,667 taxable capital gain in that year.
The reserve is optional. You can claim the maximum, none of it, or any amount in between.
Inventory sold at a profit in a year is eligible for a reserve of up to the portion of the profit from the sale equal to: profit x (proceeds due after year / total proceeds).
The reserve can normally only be claimed for a maximum of 3 years including the year of sale (more specifically, only in a year that ends 36 months or less after the date of sale). Furthermore, unless the inventory is real estate, you can claim a reserve only if part or all of the proceeds are due at least two years after the date of sale. The reserve is optional. Again, any reserve claimed is included back into income the next year, and a new reserve can be claimed if it still qualifies.