My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, May 9, 2016

Capital Gains Reserves

Last year, I asked you, my readers, for some topics you would like me to write about. One reader suggested I discuss the subject of the capital gains reserve and tax planning around the reserve. As they say, better late than never. Today I will discuss the machinations of the capital gains reserve and some planning, especially in respect of the sale of a cottage to other family members.

The reader, who asked the question, stated that his 65 year-old spouse was going to sell a rental property and wondered if it made income tax sense to transfer half the property to their son before the sale. I will address that question later in the post.

What is the Capital Gains Reserve?


The Income Tax Act ("The Act")  contains a provision [subparagraph 40(1)(a)(iii)] that allows you in general, to claim a capital gains reserve where all of the proceeds from a sale of capital property (typically real estate or shares in a corporation) will be not be received in the year of sale. To make a claim you must file form T2017 – Summary of Reserves on Dispositions of Capital Property with your income tax return.

The Act states that at least one-fifth of the capital gain must be reported in the year of sale and each of the following four years (where the gain arose because of a transfer to your children of certain farm property, fishing property or shares of an Small Business Corporation, you typically can claim a ten year reserve).

Thus, the maximum reserve for each year is as follows:

Year of sale - 80%
2nd Year - 60%
3rd Year - 40%
4th Year - 20%
5th Year – nil

I say maximum, because the reserve is calculated each year based on the following formula:

The lesser of:

a) capital gain x amount payable after the end of the year / total proceeds of disposition

b) One-fifth of the total capital gain x 4 minus the number of preceding taxation years ending after the disposition

For example. If you sold your rental property for $1,000,000 and had a capital gain of $540,000 and you receive $400,000 upfront and will be paid a $150,000 for the next four years, your reserve would be as follows:

Year 1 – lesser of:

a) $324,000 ($540,000 x $600,000/$1,000,000)
b) $ 432,000 (4/5 x $540,000)

Thus, the reserve would be $324,000 for year one and you would report a capital gain of $216,000 ($540,000-$324,000)

Year 2 – lesser of:

a) $243,000 ($540,000 x $450,000/$1,000,000)
b) $324,000 (3/5 x $540,000)

Thus, the reserve would be $243,000 for year two and you would report a capital gain of $81,000 ($324,000 yr. 1 reserve -$243,000 yr. 2 reserve).


Strategies and Considerations for Using the Capital Gains Reserve



Family Transfers


I mentioned earlier that the reader had asked about whether his wife should gift the property to her son before the sale to reduce the family income tax bill. Unfortunately, as I have discussed several times on the blog, transfers of property to family members result in a deemed disposition (sale) at the property’s fair market value (if the transfer is to your spouse, there is an automatic tax-free transfer unless you file an election opting out of the automatic rollover). So if the reader’s wife was selling her property for a $1,000,000 and transferred it to her son before the sale, she would be deemed to have sold the property for $1,000,000; the same consequence as if sold to an arm’s length buyer.

Timing of Repayment


What the reader's wife and anyone selling a property where the proceeds are paid over time need to understand is that you must ensure you leave yourself with enough funds to pay the income tax liability (i.e. the 1/5 required gain each year). That is typically not an issue; however, if you have a long term of repayment, say 10 or more years, this can become problematic. Therefore, for both business and income tax purposes, you will typically want full payment of your proceeds within five years.

Cottages

One of the most challenging assets to tax plan for is a family cottage. I wrote a three-part series on this topic, which you can find under my favourite posts on the right hand side of this page, under the topic, "Family Cottage".

Where you wish to sell your cottage to your children, you may want to consider allowing them at least five years to repay the purchase price and tailor the purchase terms to the capital gains reserve.

If you plan to gift the cottage to your children, you will have a deemed disposition at the cottages fair market value as discussed above and you will have to report the capital gain and pay the related tax in the year of gift. Consideration should be giving to selling the cottage to your children for promissory notes which you may or may not forgive in your will. However, by selling, subject to advice by your accountant, you may be able to utilize the capital gains reserve to defer the tax on the gain for up to five years. [If your child is married, you should consult a family law lawyer before gifting or selling property to your child].


Capital Gains Guide


You may find it useful to review the CRA’s T4037 Capital Gains Guide

You should always obtain professional advice before the sale of any property; especially one is which you hope to use the capital gains reserve, as the legislation is complex. However, when used properly, the reserve can smooth your income tax liability over as many as five years.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

5 comments:

  1. Thank you for such a clear description of Capital Gains Reserve.

    At the moment I am reading your book,"Let's Get Blunt About Your Financial Affairs". I appreciate you sharing your knowledge and time to help educate the masses about topics that effect everyone. I look forward to your email blog. I must admit some of the topics are way over my head but still interesting.

    Thanks goes to your wife and family who keep you grounded in simply language and are kind enough allow time away from them to blog.

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    1. Hi Lucille

      Thx for reading the book and the blog, my wife will be happy to hear she is appreciated for her plain English efforts. I try to make my blogs readable, but some topics are just fairly complex.

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  2. Hi Mark - Great post. Is there some way to "gift" the cottage or rental property to your children and claim the capital gains reserve to spread out the gain over 5 years vs all in the year of gifting? ie, even though there will be no actual $ paid to the parents, can the reserve still be claimed?

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    1. Hi Anon

      Thx. Below is a good article on your question. However, I would get tax advice from an accountant before undertaking the transaction if you wish to use the reserve.

      http://www.dynamic.ca/eng/learning/Personal-Finances/Family-Give-The-Kids-The-Cottage-Now.investor.html

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    2. Great article - Thank you!!

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