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. Please note the blog post is time sensitive and subject to changes in legislation or law.

Rental Properties - Everything You Always Wanted to Know, but Were Afraid to Ask

In August 2011, I posted a blog titled “The Income Tax implications of Purchasing a Rental Property”. There are 300 comments and answers on this post (so many that I added a note at the end of the blog a while back, that I would stop answering questions on this specific post). I recently read through the comments and realized there were several excellent questions that have probably been “lost” in the morass of questions. Today, I have decided to highlight some of the better questions. In some cases I have expanded my answers.

Questions and Answers Related to Rental Properties

Q: With respect to rental income being considered passive and therefore taxed at the high rate - is there are certain point or threshold when a real estate company's rental income is considered active and therefore eligible for the small business deduction? Is it still considered passive when you grow to a certain number of properties or employees?

A: Chris, great question, the answer is yes. A real estate company would be considered a specified investment business and not eligible for the small business deduction. However, if the corporation employs greater than 5 full time employees, the income is deemed active and eligible for the small business rate of 15.5% or so depending upon your province. I have clients with multiple corporations, each owning a single rental property. If one of the corporations has more than five employees, who really are also employees of the other corporations, it may be problematic to claim the active tax rate in that corporation. You may be able to utilize a management company, however, where the rental properties are residential, they cannot claim back the HST they pay, so a management company may not work.

Q: This is the best rental property tax blog that I have seen for Canada (Bloggers note: I just selected this question because of the opening sentence to this question :).

My question is about net loss and the government. My husband and I make over $300K in combined income. We own a 1.3 Million dollar home and it has no mortgage. We are looking at purchasing a property which is close to 2 million dollars and finance the whole amount (based on LOC and new mortgage). It will clearly generate a net loss even if we get the maximum rental income. We have done the math and the savings on taxes and a moderate appreciation of the property is well worth it. We currently have a condo rental

which has generated a modest profit for the past 5 years. Does the government care if you generate a loss for an extended period of time (over 10 years)? Thank You!

A: Flattery will usually get you everywhere. But in your case, it will only get you a link to a Torys LLP newsletter. Although the link is dated, it should answer your question.This is really a question on the "reasonable expectation of profit" doctrine.

The key comment in the Tory's newsletter is the following: “Essentially the court have held that where an activity is a commercial activity – that is, it does not have a personal element-there should not be judicial or CRA scrutiny of the taxpayers business judgment for the purpose of determining whether or not the activity is a source of income".

As per the comment above, commercial activities are problematic for the CRA to attack, so they have been going after taxpayers who claim losses with any kind of personal element.

Q: My husband and I have a duplex in both our names. Both units are rented out at this time. My husband is the sole provider for the family and I stay at home with the kids. My question is how do we claim the rental? Do we claim it 50/50 or does my husband claim 100% since he is responsible for the expenses etc.

A: Legally if ownership is 50/50, you must report the income 50/50. However, for income tax, there is the issue of income attribution. i.e.: whose money was used to purchase the property or was it a Line of Credit with both names. If your husband used his money and put the property in both your names, then technically all the rental income or losses should be reported by him. Although technically incorrect, many spouses seem to ignore the attribution rules and report income/losses on a 50/50 basis.
 
Q: Hi, I love your blog and how accessible you are, thank you so much for your contributions! I have a very old house that I have been renting for five years now. The roof has to be repaired or it will soon start to leak. We want to replace the roof with life-time guaranteed shingles. Is this kind of expense a current expense since it's required to maintain the current quality of the house or a capital expense since it also increases the value of the property?

A: Great question. Technically the CRA may say you have improved your roof by purchasing shingles that are better than the prior shingles or the lifetime guarantee makes them better than the prior shingles and thus the cost should be capitalized. However, I would suggest that the majority of accountants would likely expense the cost and argue this is purely a repair, but it is not 100% clear. 

Q: I purchased a revenue property in Quebec 5 years ago and I am planning on possibly selling it this year. Can I amortize the capital gains from the sale over 5 years? I am considering possibly selling it and buying another revenue property immediately afterwards. I.e. during the same year. I was told that if did do this then the capital gains from the sale of the property would not need to be declared since I am using the profit to buy another property. Is this true?

A: For capital gains there is typically a five year reserve available where all the proceeds have not been received on sale, see this example. In respect of the second part of this question, you are asking about the replacement property rules. These rules would not typically apply to rental property purchases and re-purchases, but relate to business properties replaced. This paper from CGA Magazine discusses the issue.

Q: I have a couple of rental houses and currently considering incorporating them to credit proof my personal assets. I understand that the rental income is treated as passive income so no benefit, but is there a difference if the rental property was sold through a corporation or held personally - i.e. can the capital gain be reduced capital gains exemption?

A: The capital gains exemption is not available on the sale of shares where the underlying asset is a rental property not used in an active business. The benefit of incorporation is pretty much creditor proofing and maybe some income splitting with your spouse depending upon the circumstances.

Q: Hi, Great blog. I purchased a 2 floor office condo (525k, 2800 soft) and its part of a 6 unit block of 2 floor office condos. One floor I rent out and one floor I use for my business. I can't find anything to indicate the value of the land for tax allocation. Do you think using the 10% rule of thumb would be appropriate in this situation and would a rule of thumb satisfy CRA?

A: Where there is no hard evidence to determine the allocation between land and the building, it would not be unusual for many accountants to use 10% for land related to a condo. That does not mean it is correct and that the CRA would not challenge the allocation, however, I have not seen the CRA challenge this.

Q: What are the tax implications of purchasing a home for myself and family to live in as our primary residence and renting out the basement. Would it be the same implication if we put an addition on the house but we still occupied more than 50%. Thanks.

A: This is what the CRA says, I think their response answers both your questions.

"It is the CRA’s practice not to apply the deemed disposition rule, but rather to consider that the entire property retains its nature as a principal residence, where all of the following conditions are met:

a) the income–producing use is ancillary to the main use of the property as a residence;
b) there is no structural change to the property; and
c) no CCA is claimed on the property.

These conditions can be met, for example, where a taxpayer carries on a business of caring for children in the home, rents one or more rooms in the home, or has an office or other work space in the home which is used in connection with business or employment. In these and similar cases, the taxpayer reports the income and may claim the expenses (other than CCA) pertaining to the portion of the property used for income–producing purposes".

Q: I have a question about % used for business on my tax return. We have a cottage rental property. We open it in the spring and close it in the fall. Out of the 16 available weeks, it was rented 12 weeks, vacant 1 week, and personal use for 3 weeks. The 1 vacant week was advertised for rent but we did not get a booking. The remaining 36 weeks a year, the cottage is not accessible, the roads are not maintained and the

cottage is not heated.

How do I calculate percentage used for business? Is it just the rented weeks (12) or available for rent weeks (13)? And in the denominator, can I use 16 weeks or do I have to use the whole year.

A: See the discussion in this paper about your issue.

The paper says this. “In the Morris case, the decided that the portion of the operating losses to be written off against income was the percentage that is was available for rent during the operating season. Since the cottage was frozen for a portion of the year and therefore not rentable, the expenses for that period of time were not deductible.

As a result of these decisions and others, the Canada Revenue Agency is taking the position that if you use the property personally and rent it out the rest of the time, your business use is only the period when you can "Reasonably expect to rent out the property.”

Keep in mind that this is the CRA’s view, I am sure lots of people do not necessarily agree with their position, but if you take an alternative position, you may be challenged.

As you will have observed from the above Q&A, some of the income tax issues that arise in respect of owing a rental property are complicated or fall into a murky grey area. I would suggest that if you own a rental property, you should probably have an accountant assist with your income tax return.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.