How the Capital Gains Reserve Works When You Are Paid Over Time in Canada

Selling a property and being paid in instalments can create a tax problem. The gain is normally reported in the year of sale, yet much of the money may not arrive until later years. A capital gains reserve is the tool that lets you hold back part of the gain until the cash comes in.

This article explains how the reserve works, how much you can claim in each year, when a longer period applies, when you cannot use it at all, and how the claim is made. Your facts decide the details, so use this as a map and not as a final answer.

This article covers Canadian federal tax law, which applies in every province.

What the reserve does

When you sell capital property, the gain is the proceeds minus the adjusted cost base (ACB) and the outlays and expenses of selling. Normally the taxable half of that gain lands on line 12700 of your T1 return and is taxed at your marginal rates along with your other income. If part of the price is payable after year-end, you may be able to claim a reserve, which defers part of the gain to later years.

Most capital gains reserves can be claimed for a maximum of four years after the year of sale, so the gain is included in income over five years. You do not have to claim the maximum, and the reserve is an option, not an obligation.

How much you can claim each year

Section 40(1)(a)(iii) of the Income Tax Act sets two limits. The reserve cannot be more than a reasonable amount for the proceeds that are payable after year-end, and it cannot be more than a fraction of the gain equal to 1/5 times the figure by which 4 exceeds the number of preceding taxation years. The first limit follows your payment schedule. The second is a hard time limit.

Working through that formula, the table shows the largest reserve you can claim in each year and the smallest total share of the gain that has been included by the end of that year (a running total, not the amount for that year alone) for a standard five-year case.

In plain terms, at least 1/5 of the gain is included each year, starting with the year of sale. A reserve claimed last year must also be brought back into this year's gain.

Claiming less than the maximum

You can claim a smaller reserve than the maximum if, for example, you would rather use a low-income year to report more of the gain. A later-year claim cannot exceed the amount claimed for that property the previous year. That means a reserve can shrink over time but cannot grow back.

Because the taxable gain is added to your other income and taxed at marginal rates, spreading the gain can matter. Whether it actually lowers your total tax depends on your income in each of the years, so it is worth modelling with an accountant.

Longer periods and cases where no reserve is available

Some transfers get a longer runway. For transfers to a child of family farm or fishing property or qualified small business corporation shares, and for qualifying business transfers, the reserve runs nine years, so the gain is included over 10 years. The statute replaces 1/5 and 4 with 1/10 and 9 in s. 40(1.1).

There are also situations where you generally cannot claim a reserve:

• You were a non-resident in the relevant tax year.
• You were exempt from tax.
• You sold the property to a corporation you control, in the relevant tax year or the following year.

How a reserve applies if the seller dies or leaves Canada depends on the facts, so it is worth confirming with a lawyer or accountant. On death, the deceased is considered to have sold capital property, and inherited property generally costs the heir the deceased's deemed proceeds of disposition, usually fair market value just before death.

Claiming the reserve on Form T2017 and what to do next

You claim the reserve on Form T2017, and you enter line 31 of T2017 on line 19200 of Schedule 3. The sale itself is reported on Schedule 3 in the calendar year it occurs, and you should file a return even if no tax is owing. Report amounts in Canadian dollars.

• Keep the sale agreement showing when each instalment is due.
• Work out the ACB and your selling costs so the total gain is right.
• Calculate the maximum reserve and decide how much to claim.
• Complete Form T2017 and carry the result to Schedule 3.
• Each following year, bring last year's reserve into income and claim a new reserve that is no larger than last year's.

If the property is a farm, fishing property, small business shares, or is going to a related buyer, speak with a lawyer or accountant before you sign, since the rules above change with the facts.

Frequently asked questions