A capital gain occurs when you dispose of a capital property for proceeds in excess of your adjusted cost base. Generally, 50% of the capital gain is taxable in the year of disposition. However, a capital gains reserve may be available to defer a portion of the taxable capital gain if you do not receive the full amount of the proceeds in the year of disposition. This reserve may allow you to defer payment of income taxes until the proceeds are received.
A reserve is generally available unless one of the following conditions applies:
You were not a resident of Canada at the end of the tax year, or at any time in the following year;
You were exempt from paying tax at the end of the tax year, or at any time in the following year; or
You sold the capital property to a corporation that you control in any way.
The amount of the reserve is calculated as the lesser of:
Capital gain × Proceeds receivable at year-end/Proceeds of disposition; and
1/5 × Capital gain × (4—number of preceding tax years ending after the disposition)
In effect, the above calculation limits recognition of the capital gain to a five-year period. Assuming the proceeds are received over a period of five years or more, 20% of the capital gain will be recognized each year. If the proceeds are received evenly over two years, 50% of the gain must be recognized each year.
For example, consider the following numerical example:
You sell shares of a private corporation for proceeds of $1,000,000. Your adjusted cost base of the shares is $100,000.
Based on the above, you must recognize a taxable capital gain of $900,000 ($1,000,000 - $100,000) in the year of sale.
The proceeds of $1,000,000 will be paid evenly over a four-year period ($250,000 per year).
Based on the above, the maximum capital gains reserve that can be claimed in the year of sale is the lesser of:
$900,000 × $750,000/$1,000,000 = $675,000; and
1/5 × $900,000 × (4 - 0) = $720,000
Therefore, you must recognize a capital gain of $900,000 less a reserve of $675,000 in the year of sale for a net amount of $225,000. In the following year, the prior year reserve of $675,000 will be taken into income, and a reserve of $450,000 ($900,000/$1,000,000 × $500,000) will be available to claim. Once again, the net amount will be $225,000. This process will be repeated in years three and four until the entire amount of the proceeds have been received.
A reserve may be claimed over a ten-year period on certain dispositions. This applies if you dispose of certain properties to a child, grandchild or great grandchild who is a resident of Canada at the time of the disposition. The properties to which this applies includes family farm property, a share in the capital stock of a family farm corporation, an interest in a family farm partnership, or a share in the capital stock of a small business corporation.
Claiming a capital gains reserve can be very beneficial when you do not have the cash available to pay tax on the full amount of the capital gain. However, there are additional considerations and it may not always be advisable to claim the full amount of the reserve.
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