If you sell property, you are normally required to report the gain or profit in the year in which the proceeds of disposition become receivable. Therefore, you may be required to include the gain or profit in income in the year of disposition, even though you have not received all of the proceeds.
Fortunately, there are two reserves that apply in these circumstances. One is a capital gains reserve, which applies where the disposition of the property gives rise to a capital gain. The second is an inventory reserve, which applies where the disposition is made in the course of a business of selling the property.
Each reserve is deducted in computing the gain or profit. It is then added back in the next year, and a further may be claimed if proceeds are still owing at the end of that next year, subject to the limits described below.
Capital gains reserve
The maximum amount you can claim in a year is limited to the lesser of two amounts:
- a “reasonable reserve”, which is usually the amount equal to (gain x proceeds due after the year / total proceeds); and
- a fraction amount, which varies depending on the year.
The fraction amount is: 4/5ths for the year of disposition, 3/5ths for the following year, 2/5 for the year following that, and 1/5 for the year after that. So the reserve can be claimed only for 4 years, which means that the gain may be spread out for a maximum of 5 years.
In 2016, you sell a capital property and realize a $100,000 capital gain. You receive 1/3rd of the proceeds in 2016, with another third due in each of 2017 and 2018.
In 2016, you must initially report $100,000 as the capital gain. However, you can deduct a reserve equal to the lesser of ($100,000 x 2/3) and (4/5 of $100,000), or $66,667. So your capital gain will be reduced to $33,333, and half of that will be included in your income as a taxable capital gain.
In 2017, you add back your $66,667 reserve, and repeat the process to claim a reserve. Basically, in this simple example, you will be able to spread out the $100,000 gain ($50,000 taxable capital gain) over three years.
If you are in the business of selling the property, the reserve in any year is simply the “reasonable reserve” amount, which is (profit x proceeds due after the year / total proceeds). The reserve claimed in one year is added back in the next year, and the process continues if proceeds are still due after that next year. The reserve is normally available for only up to 3 years, which means the profit can be spread out over a maximum of 4 years.
The other “catch” for the inventory reserve is that, if the property is not real estate, it can be claimed only if part or all of the proceeds are due at least 2 years after the date of sale.