Capital GainsThe reserve mechanism may allow some capital gains to be deferred when disposing of property.
Determining capital gains on the disposition of property can be tricky when some or all of the sale proceeds aren't payable until after the taxation year. The most common example of this type of situation is where the selling taxpayer provides a mortgage to the buyer — a vendor-take-back (VTB) — on the sale of real estate. This could put the seller in the unenviable position of having to pay income taxes on a gain they've not yet received. Fortunately, the Income Tax Act (the Act) provides a mechanism, called a reserve, by which some of the gain can be deferred.
In terms of tax compliance, the reserve approach functions quite simply. Whatever amount the taxpayer claims as a reserve against the capital gain this year is brought into income the following year, and a new or further reserve is claimed the following year. This process is repeated until no available reserve remains, either because there is a time limitation or the debt receivable has been fully paid. For individuals, prescribed form T2017 is used for reporting and continuing a reserve.
The capital gains reserve for proceeds not due is found at subsection 40(1) of the Act. Unfortunately it's far from perfect because it doesn't really match cash and income as there is, with certain exceptions, a five-year "cap" on the maximum deferral period. However, that's better than no reserve at all. Prior to November 13, 1981, where the reserve arose from a disposition of property, there was no statutory "cap" in the number of years the gain could be deferred. And, while this may have been a more equitable approach, it no longer exists.
Under subsection 40(1) the maximum capital gains reserve that may be claimed in any particular year is limited to the lesser of:
||a reasonable amount, and|
||80 per cent of the original capital gain in year one, 60 per cent in year two, 40 per cent in year three, 20 per cent in year four, and zero in year five.|
There is no definition in the Act as to what constitutes a "reasonable amount" but, as noted at archived IT-236R4, it is generally accepted that it results from the formula:
Two things are worth noting here, and both arise from the fact that use of the reserve is optional. If desired, the taxpayer can report the whole gain in the year the property is disposed of, or they can, in the year of sale or any one of the future years, claim something less than the permitted maximum reserve, even zero. This provides the taxpayer with the flexibility to bring the otherwise deferred capital gain into income whenever that would be to his or her advantage.
On a real estate sale there is an alternative approach to a reasonable reserve where, in addition to the VTB, the buyer assumes an existing mortgage on the property. In this situation — and based on my experience, this is little known — the vendor can adjust the denominator in the reasonable reserve formula so that it represents the equity disposed of.
In the right circumstances this will increase the available reserve, although it is still subject to the five-year maximum period.
There is a widely-held belief that the (b) factor of the maximum reserve calculation (the declining percentage) leads to a requirement that a minimum of 20 per cent of the gain must be included in income in each of the five years. This is a fallacy.
Exhibit 1 illustrates the five-year reserve process for a taxpayer who realized a $40,000 capital gain on a property that was disposed of for $100,000 and who took back a first mortgage for $25,000. The mortgage is interest-only and is due in 10 years. In this situation while the (b) factor of the reserve will decline in each year of the five-year limit, the (a) factor (the reasonable amount) will not change. It is constant at:
At % For Year of
At Lesser of
(a) and (b)
||$ 30,000 |
||$ 0 |
||$ 0 |
||$ 2,000 |
||$ 8,000 |
Eligibility for any reserve is dependent on the taxpayer having an amount not payable (synonymous with "not due") until after the end of the taxation year. Determining whether an amount is due is not always easy. For example, a simple promissory note payable on demand is not an amount not due. That demand note is due the instant it's written as the note holder is entitled to enforce payment. Consequently there is no entitlement to a reserve because the note holder is only choosing not to enforce payment. Similarly, where a mortgage has gone into default, generally there is an accelerator clause which causes the whole of the mortgage to become due and so no reserve would be allowed.
The five-year cap on a capital gain reserve is extended to 10 years [the 20 per cent annual reduction in the reserve's (b) factor becomes 10 per cent] for certain property disposed of to a taxpayer's child, grandchild, or great-grandchild who is resident in Canada. The only property eligible for this extension is land or depreciable property used in a farming business in Canada, shares of a family farm corporation or an interest in a family farm partnership, and the shares of a small business corporation. The purpose of the extension is to ease the tax burden on transferring a farm or small business to the next generation.
A capital gains reserve is not available to a non-resident, nor to a person who becomes a non-resident. The latter situation is interesting in that the taxpayer is disentitled from the reserve the year before they become a non-resident. This prevents an emigrant from minimizing their marginal tax rate on the deferred gain by leaving Canada early in the next year.
Another situation in which there is no entitlement to the reserve is when the purchaser is a corporation that is directly or indirectly controlled (as measured immediately after the sale) by the vendor, or where a subsidiary corporation disposes of property to its parent corporation. Nor is a reserve allowed where the purchaser is a partnership in which the vendor is a majority interest partner. These are, more or less, anti-avoidance provisions to prevent abuse.
The last aspect of the capital gains reserve we'll look at in this article is what happens in the year of death. When a taxpayer dies, the full amount of any remaining reserve from the preceding year is classified as income in their terminal tax return. If the underlying debt receivable supporting the reserve is transferred to their spouse or common-law partner, an election can be filed (form T2069) to continue the reserve in the deceased's terminal return and the remaining reserve, both the amount and the years left in the cap rolls over to the spouse. This election should only be made where it's advantageous, as it may be more tax efficient for the deceased to have the reserve balance as income.
So, while not a perfect solution, the capital gain reserve is nonetheless another tool in the practitioner's tool box which can be used in the appropriate circumstances as a tax planning device for clients.
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