Capital gains reserve more beneficial after inclusion rate hike

Taxpayers who don’t receive all the proceeds on the sale of a property in the year of sale may defer the tax associated with the gain over as many as five years (10 years for certain property) using the capital gains reserve. Generally, taxpayers must claim at least 20% (10% for certain property) of the gain annually during that period.

The amount actually paid to the seller must be claimed in a year, so the seller can claim the reserve only if the terms of the deal provide for deferred payment. However, even if payments are staggered, a seller could choose to pre-pay the tax on the gain by not claiming the reserve.

The new CGIR rules allow taxpayers with a reserve to access the annual $250,000 threshold for individuals.

For example, clients who transfer a cottage to a child or grandchild in exchange for a promissory note or demand letter can spread the inclusion of the gain over five years, said Jacqueline Power, assistant vice-president of tax and estate planning with Mackenzie Investments in Toronto.

Depending on the size of the capital gain associated with the disposition, claiming a reserve over multiple years might “keep a taxpayer annually below the $250,000 threshold and allow them to continue to have that 50% inclusion rate,” Power said.

If the cottage were gifted to the child, the client would be deemed to sell the property at fair market value and couldn’t claim a reserve on the associated gain. However, “by structuring it as a virtual sale using a demand loan or promissory note, the property is sold,” Power said, “but all the proceeds are generally not being collected at once, which is how the capital gain can be spread out over time.”

A taxpayer who realized a significant capital gain — say, from a business sale before June 25 — may benefit from paying the tax related to the gain in 2024, rather than claiming a reserve and exposing portions of the gain to the higher CGIR in 2025 and beyond, said Ameer Abdulla, a partner with EY Canada in Waterloo, Ont.

When a capital gain is brought out of reserve in a subsequent year, it is subject to the CGIR applicable for that year, the Canada Revenue Agency (CRA) stated in a June 10 backgrounder document.

For example, if a reserve is claimed for a capital gain first realized in 2023 or earlier, any portion of that gain brought into income in 2025 would be included at the one-half CGIR below the $250,000 threshold for individuals, but at the two-thirds CGIR for any portion above that.

The CRA also said that, for tax years that include June 25, 2024, the amount of a capital gain brought out of reserve would be subject to the CGIR in effect on the first day of the taxpayer’s tax year, which for individuals is Jan. 1.

That means the entire amount taken out of reserve in 2024 would be subject to the 50% CGIR for individuals.

However, “if the property is sold in Period 2 (June 25th or later) and the gain is greater than $250,000, then the portion that is included [in income] for 2024 that is above [the threshold] would be subject to the two-thirds inclusion rate,” Power said. “As the reserve is used going forward, it is considered to be included in income the first day of the [next tax] year.”

Taxpayers who sold a property before 2024 and are in the middle of an existing capital gains reserve must decide whether to continue with the planned series of deferrals in 2025 and beyond.

If the capital gain on the disposition is significant, the taxpayer may want to bring the remaining gain out of reserve this year — so all of it is subject to the 50% CGIR — rather than continue claiming capital gains reserves in future years, Abdulla said.

But if the taxpayer hasn’t yet received sufficient proceeds from the sale, they may not have the cash flow to pay the tax associated with claiming all remaining gains.

“That’s actually why the [capital gains] reserve exists — so you can match the inclusion of the [gains in] income with the cash received,” Abdulla said.

A silver lining for taxpayers is that the decision of whether to claim a reserve this year is not tied to the June 25 effective date for the new CGIR, but rather to the tax return deadline for 2024.

“We have a bit more time to be thoughtful about it,” Abdulla said.

All taxpayers — individuals, corporations, trusts and partnerships — may claim a capital gains reserve. However, only individuals and certain trusts have access to the $250,000 annual threshold.

For corporations, most trusts and partnerships, the benefit of claiming the capital gains reserve would be limited to deferring the payment of tax to match the receipt of proceeds of disposition, Abdulla said.

What is the capital gains reserve?

When a taxpayer sells capital property and receives payment over multiple years, they may be able to claim a capital gains reserve. Typically, a reserve allows a taxpayer to report a portion of the capital gain in the year they receive the proceeds of disposition.

Generally, the maximum period over which most reserves can be claimed is four years following the year of disposition (five years total). However, a nine-year reserve period (10 years total) is provided for transfers to a child of family farm or fishing property or small business corporation shares, as well as gifts of non-qualifying securities made to a qualified donee.

Amendments in Bill C-59, which passed third reading in the Senate Wednesday, would extend the 10-year reserve deferral period to shares transferred as part of an intergenerational business transfer or sold to an employee ownership trust.

To claim a reserve, a taxpayer calculates the capital gain for the year as the proceeds of disposition minus the adjusted cost base. From this, the taxpayer deducts the amount of the reserve for the year, leaving the portion of the capital gain that the taxpayer must report in the year of disposition. In general, taxpayers must claim at least 20% (10% for certain property) of the gain annually through the capital gains reserve period.