Capital Gains Reserve When the Buyer Pays Over Several Years

Many owners do not get all of the sale price on closing day. The buyer pays a deposit, then the rest over several years through a vendor take-back or instalments. You may wonder whether you must pay tax on the whole gain in the year of sale even though you have not yet received the money.

The capital gains reserve is the tool that often answers that question. This article explains the general rule, the longer rules for certain family and employee transfers, and the questions to settle with your accountant before the deal terms are final.

What the capital gains reserve does

When you sell capital property and part of the price is payable after the end of your tax year, the Income Tax Act allows you to claim a reserve. In plain terms, the reserve lets you leave part of the gain out of income for now and report it in later years as you are paid.

The general reserve under s. 40(1)(a)(iii) is limited to the lesser of two amounts: a reasonable amount for the proceeds that are payable after year-end, and 1/5 of the gain multiplied by (4 minus the number of preceding years ending after the disposition). The practical result is that the gain must be brought into income over at least 5 years.

Notice that there are two limits. Even if the buyer is allowed ten years to pay, the general reserve still forces the gain into income within the five-year pattern. Equally, if you are paid most of the price at closing, the reasonable-amount limit will keep the reserve small.

How the five-year pattern works year by year

Using the formula in s. 40(1)(a)(iii), the most you can reserve shrinks each year as the number of preceding years goes up. The table shows the maximum reserve as a share of the gain, assuming enough of the price is still unpaid to support it.

Because the maximum reserve gets smaller each year, the deferred gain moves into your income over at least 5 years. If you are paid faster than the formula requires, the reasonable-amount limit means less can be reserved.

When the reserve can last 10 years

Section 40(1.1) swaps 1/10 and 9 for 1/5 and 4, which extends the reserve to 10 years. It applies to farm or fishing property, shares or partnership interests in a family farm or fishing corporation, and qualified small business corporation shares, when they are disposed of to a child resident in Canada.

Other transfers also get the 10-year period:

• Shares sold to another corporation where the immediate or gradual intergenerational business transfer conditions in s. 84.1(2.31) or (2.32) are met.
• Shares disposed of under a qualifying business transfer to an employee ownership trust (EOT).
• Shares disposed of under a qualifying cooperative conversion.

Whether your sale fits one of these categories turns on detailed conditions. If you are selling to a child or to a trust for employees, ask your advisor to confirm each condition before you rely on the longer period. Our related article on selling to a child's company covers the intergenerational rules.

The reserve and the lifetime capital gains exemption

The lifetime capital gains exemption (LCGE) can shelter gains on qualified small business corporation shares. The limit is $1,250,000 for dispositions after June 24, 2024, and it is indexed using Statistics Canada's Consumer Price Index. For dispositions in 2026, the CRA lists the limit as $1,275,000. Confirm the amount for your year of sale.

The deduction is calculated on Form T657, and the allowable amount is claimed on line 25400 of the T1 return. Your available deduction can also be lower than the headline figure, because allowable business investment losses reduce the annual gains limit and a positive cumulative net investment loss reduces the cumulative gains limit.

How the reserve and the exemption interact in a particular deal depends on the facts, including how much of the gain is included in each year and how much of your exemption is already used. This is a point to model with an accountant before you agree to instalment terms, because the order and timing of the claims can affect your result.

What to do before you agree to instalments

The tax result is shaped by the payment terms, so raise these questions while the letter of intent or purchase agreement is still being negotiated.

• Write down how much is paid on closing and how much is payable later, and by what dates.
• Ask whether the sale fits one of the 10-year situations or only the general five-year reserve.
• Confirm that your shares qualify for the LCGE and what your year-of-sale limit is.
• Ask your accountant to check for allowable business investment losses and cumulative net investment loss that could shrink the exemption.
• Ask whether the exemption claim could raise alternative minimum tax in the year of sale.
• Consider security for the unpaid balance, because tax planning does not help if the buyer cannot pay.

Bring your draft agreement, your financial statements and your prior-year tax returns to a lawyer and an accountant. They can confirm which reserve applies and how to word the payment terms.

Frequently asked questions