As readers are likely aware, if you sell a capital property like real estate or securities and your proceeds of disposition exceed your cost of the property (plus any sales costs like commissions), you will have a capital gain. Your “taxable capital gain”, included in your income for tax purposes, is one-half of the capital gain.
However, if some or all of the proceeds of disposition are due after the year of sale, you do not have to pay tax on the entire taxable capital gain in that year. In most cases, you can claim a “capital gain reserve”, as described below. Although you must still include a portion of the gain in the year of sale, you can normally spread out paying the tax on the entire gain over up to five years.
The reserve is optional. It might not be claimed if you have capital losses that could offset the capital gain, or if you expect to be in a higher tax bracket in future years.
Assuming you choose to claim it, the capital gain reserve is the lesser of two amounts:
- The portion of the capital gain that can reasonably relate to the proceeds of disposition that are due after the year. This portion is determined by multiplying the amount of the capital gain by (proceeds due after year / total proceeds).
Put another way, this is the portion of the gain that isn’t yet received in the year.
The second amount is a fraction multiplied by the amount of the capital gain. Basically, in the year of sale the fraction is 4/5ths of the gain, and in the three subsequent years the fraction is 3/5ths, 2/5ths, and 1/5th, respectively. After four years of claiming the reserve, any remaining gain after that point will not be eligible for the reserve and you will have to report the remaining gain, if any, in the fifth year.
Put another way, you must recognize at least 1/5th of the gain, cumulatively, each year beginning in the year of sale.
When you claim the reserve for a given year, you add the amount you claimed back into your capital gains for the next year. But you may be able to claim the reserve again for the next year, assuming some proceeds are still not due until after that year.
In 2022, I sell some land for $600,000. My cost of the land was $100,000. So I initially have a capital gain of $500,000.
Under the sales agreement, the purchaser will pay me $100,000 in 2022, and $100,000 in each subsequent year until the full purchase is paid, which will be in 2027.
In 2022, I can claim a reserve equal to the lesser of:
- The $500,000 capital gain x ($500,000 proceeds due after 2022 / $600,000 total proceeds), which comes to $416,666; and
The $500,000 capital gain x 4/5, which comes to $400,000.
Put another way, I’m getting only 1/6th of the proceeds in 2022, but I have to recognize at least 1/5th of the gain this year.
Assuming I claim the $400,000 reserve, I will report a capital gain of $100,000 in 2022. One-half of that gain will be included in my income in 2022 as a taxable capital gain.
In 2023, I add back the $400,000 reserve claimed in 2022 into my income. But then I can again claim a reserve. It will be the lesser of:
- The $500,000 capital gain x ($400,000 proceeds due after 2023/ $600,000 total proceeds), which comes to $333,333; and
The $500,000 capital gain x 3/5, which comes to $300,000.
Therefore, I will report a capital gain in 2023 of $100,000, i.e. the $400,000 reserve add-back minus the $300,000 reserve. Again, one-half of that gain, being $50,000, is included in my income in year 2 as my taxable capital gain.
The reserve mechanism could continue through 2025, after which a reserve would be not available (since, as noted above, it is only available for four years). Therefore, the remaining capital gain would have to be reported in 2026 (the 5th year), even though some proceeds are not due until 2027.
Other limitations on the capital gains reserve
You cannot claim the reserve if you sell property to a corporation or partnership that is controlled by you immediately after the sale. Control includes 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 cannot be claimed if the purchaser of the property is a corporation controlled by the same person or group of persons that control the vendor corporation. Similarly, the reserve is not allowed if the purchaser corporation controlled the vendor corporation.