In most cases, the Canada Revenue Agency requires you to report and pay taxes on capital gains in the year that they occur. However, if you don’t receive full payment for the asset right away, you may be able to claim a reserve. This allows you to report your capital gains in increments as you receive the payments.
In order to claim a reserve, you must be a resident of Canada at the time the disposition occurs, and you must not be exempt from paying tax. Additionally, if you sold the capital property to a corporation you control, you cannot claim a reserve.
The Reserve Period
In most cases, you may only claim a reserve over the course of five years, regardless of how long it takes you to recoup the entire payment.
However, if you have capital gains from giving qualified capital assets to your child, the CRA offers you a ten year reserve period. To qualify, the property must be family farm property, family fishing property, or qualified small business corporation shares.
Similarly, if you donate capital property to a charity and the gift is not fully tax deductible, you may use the 10 year reserve period. This allows you to pay taxes on your capital gain slowly.
Calculating Capital Gains
In order to understand the value of the reserve period, you need to understand how the CRA calculates capital gains. In most cases, you subtract the adjusted cost base of the asset (the cost plus any expenses incurred to purchase it) from its selling price.
For example, if you sold shares for $800,000 and you bought them for $400,000 and paid $1,000 in broker fees, the adjusted cost base of your asset is $401,000, and your capital gains are $399,000.
However, in cases where you dispose of a capital asset for less than its fair market value, the CRA requires you to calculate your capital gains using the asset’s FMV rather than its selling price. For example, if you give a capital asset such as a house to your child as a gift, you should have it appraised and report the capital gains based on its appraised value.
Luckily, as indicated above, many gifts of capital assets to your children qualify for a reserve.
Calculating the Reserve
The CRA calculates your reserve by multiplying your qualifying capital gain by a certain percentage each year.
If your capital gain qualifies for a five year reserve, your reserve is 80 percent of your capital gain in the year of sale. For each of the following years, the percentage drops by 20 percent.
For example, if you sold an apartment building for $1 million and you acquired it for $200,000, your capital gain is $800,000. If you qualify for the reserve, in the year of sale you may claim a reserve of $640,000.
When you subtract this reserve amount from your capital gain of $800,000, you only have to report a capital gain of $160,000. This significantly lowers your income and your tax owed for the year.
If your capital gains qualify for a ten year reserve, the CRA calculates your annual reserve by multiplying your qualifying capital gains by 90 percent in the year of sale. This figure decreases by 10 percent each year.
Completing Your Tax Return
If you qualify for a reserve, use form T2017 to calculate the maximum amount you can deduct. After entering your information and working through the formulas on the form, transfer the amount from line 6706 of this form to line 192 of schedule 3 from your federal income tax return.
If you have capital gains or losses, schedule 3 helps you to calculate the amounts to claim on your income tax return. When you have completed schedule 3, if the number on line 199 is positive, enter it on line 127 of your income tax return. This is your capital gains for the year.
Don’t Forget the Lifetime Capital Gains Deduction
Before claiming the reserve, make sure that your capital gains do not qualify for an exemption. The lifetime capital gains exemption provides you with an exemption from paying taxes on qualifying capital gains.
This includes gains from the disposition of qualified small business corporation shares and qualified farming and fishing properties. If you qualify, you may claim a deduction worth up to $406,800 for qualified small business shares and up to $500,000 for qualified farming and fishing property.
The capital gains that qualify for the ten year reserve period typically overlap with the capital gains eligible for the LCGE. This means that if the exemption doesn’t cover all of your capital gains, you may be able to claim a reserve and report the remaining capital gains over a ten year time period, paying your taxes slowly.