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Kevin Greenard: Utilizing the capital gains reserve can save tax dollars

When capital property is sold, a capital gain or loss is realized. This capital gain or loss is calculated as the difference between the proceeds on disposition and the adjusted cost base of the capital property.
Kevin Greenard

When capital property is sold, a capital gain or loss is realized. This capital gain or loss is calculated as the difference between the proceeds on disposition and the adjusted cost base of the capital property.

Capital gains receive preferential tax treatment where only 50 per cent of the gain is taxable. This rate is referred to as the inclusion rate, and the portion that is taxed is referred to as the taxable capital gain.

Prior to February 23, 1994, Canadians could make a $100,000 general lifetime capital gains election on disposition of certain capital property and pay no tax at all. This was eliminated on February 22, 1994. Our clients that own businesses and have qualifying small business shares are still able to claim the lifetime capital gains exemption and pay no tax at all on the first $883,384 (2020) of capital gains on the sale of their business, which is equivalent to $441,692 (2020) of taxable capital gains (at the current 50 per cent inclusion rate). There is a larger lifetime capital gains exemption of $1,000,000 ($500,000 of taxable capital gains) for owners who sell their qualified farm or fishing property. If you had previously used the entire $100,000 general lifetime capital gains exemption before it was eliminated in 1994, then you have $900,000 remaining.

Apart from what used to be the $100,000 general lifetime capital gains exemption, the lifetime capital gains exemption on qualifying small business shares, and the exemption on qualified farm and fishing property, there is no other mechanism to avoid tax on capital gains. The next best option is deferral and spreading the gain to avoid a significant tax liability in the year of disposition.

The transition into retirement for many of our clients involves either selling a business and/or selling a commercial related property. When a client begins talking about this, we plant the seed of the capital gains reserve.

Capital Gains Reserve

Generally, the tax liability on capital gains is calculated in the same taxation year the sale took place and paid the following year when those taxes are filed. Canadian resident taxpayers may, however, be able to defer part of the capital gain, and the taxes related to it, by utilizing the capital gains reserve. A few criteria must first be met in order to qualify for the capital gains reserve. First, the proceeds must be received over a number of years (up to a maximum of five years, or ten years for farm and fishing property). Second, you must be a Canadian resident who has not been exempt from paying tax, and who will not be exempt from paying tax in the following year. Third, you cannot sell the capital property to yourself through a corporation that is under your control.

How does it work?

The capital gain reserve is calculated as the lesser of: the capital gain divided by the proceeds from disposition, which is then multiplied by the remaining proceeds received after the year-end; and one fifth of the total capital gain, multiplied by four (in the first year the reserve is taken, three in the second year the reserve is taken, two in the third year, one in the fourth year, and zero in the fifth year).

The result of the latter portion of the above calculation is that in the year the capital property is sold, no more than 80 per cent of the gain can be taken as a reserve. In the year after the capital property is sold, no more than 60 per cent of the gain can be taken as a reserve, and so on until the fifth year when there is no longer a capital gains reserve and the remaining gain must be fully brought into income.

Other considerations

There are several points to consider when using a capital gains reserve. Two main considerations being cash flow needs and risk of default. Before using this strategy, it is important to assess both your immediate and future cash flow needs. With the capital gains reserve approach, the total cash value of the sale of the capital property will not be received for two to five years, depending on the agreement between the buyer and the seller. It is key to first assess your cash flow needs, factoring increased cash flow requirements from the tax bill, to determine if this strategy is feasible.

The second key consideration is risk of default. If payment is not fully received up-front at the time of sale, there is a possibility that the third-party buyer could default on their future payments. It is important to assess the creditworthiness of the buyer and make provisions for such an occurrence in the sale agreement.

Another aspect to consider is your future tax bracket. If your tax bracket will significantly decrease in the coming years, it may then be beneficial to delay the sale into a future tax year, or receive payment over five years to maximize the deferral through the capital gains reserve. Even if proceeds are structured to be received in a subsequent year, a minimum of one fifth of the gain must be realized in the year of disposition, and each year thereafter.

Lastly, age is another factor to take into consideration. If you are approaching retirement and will begin collecting Old Age Security (OAS), using the capital gains reserve today could result in a clawback of your OAS benefits in future years. It may be important to consider this while determining the terms of the sale.

Illustration 1: Sale of a commercial building

To illustrate how the capital gains reserve works, we will look at a potential scenario. Dr. Jones who is retiring this year and just sold his commercial building, which he runs a clinic out of. The adjusted cost base (ACB) of Dr. Jones’ building is $1,000,000, and he just sold it for $2,200,000. His capital gain is equal to the purchase price, less the ACB: $2,200,000 - $1,000,000 = $1,200,000. If Dr. Jones received payment in full in the year of sale, half of this gain, or $600,000, would be taxable in that year.

From working through the year, Dr. Jones already has $250,000 in taxable income. Dr. Jones will have to pay a combined federal and provincial income tax of $90,843 on this income. By including this additional $600,000 taxable gain in the year, Dr. Jones’ taxable income increases to $850,000 and his income tax liability would jump from $90,843 to $411,843. The additional tax liability of $321,000 is equal to 53.5% (the highest marginal tax bracket in British Columbia) of the taxable capital gain, and is fully attributed to the capital gain on the sale of the clinic’s building. These would be the taxes if Dr. Jones were to sell the building in a year he has high income from other sources and receives full payment for the sale of the building in that year.

In our conversations with Dr. Jones, he anticipates being in a much lower tax bracket in retirement. Our recommendation to Dr. Jones was to defer the sale of the building to early next year when his income would drop from $250,000 to $70,000, and to claim a capital gains reserve between two to five years. In doing this, not only could Dr. Jones spread the income tax burden over a two to five period, but he could also significantly decrease the total tax bill on the sale of the building.

We will illustrate the tax savings Dr. Jones would have if he were to receive payment for the sale of the building in equal, annual payments over five years. In retirement, Dr. Jones will have annual income of $70,000, as stated above, on which he will pay $13,431 in income taxes. Adding one fifth of the taxable capital gain ($120,000) would increase his income to $190,000, and his taxes to $60,775. The portion of the taxes attributable to the sale of the building is $47,344. If Dr. Jones paid $47,344 annually in additional taxes for five years, the total taxes paid attributable to the building would be $236,720. Comparing this to the taxes owing if the building was sold in the year of retirement of $321,000, Dr. Jones would save $84,280 in taxes under this option. Each year, the capital gains reserve would be calculated as follows:

The capital gains reserve is calculated as the lesser of:

Capital gain divided by the proceeds from disposition, multiplied by the remaining proceeds received after the year-end:

[ $1,200,000 / $2,200,000 ] x [ $2,200,000 - $440,000 ] = 0.55 x $1,760,000 = $960,000 capital gains reserve ($480,000 taxable capital gains reserve)

And

20 per cent of the total capital gain, multiplied by four years:

[ 20 per cent x $1,200,000 ] x [ 4 ] = $960,000 capital gains reserve ($480,000 taxable capital gains reserve)

Dr. Jones would then recognize 20 per cent of the capital gain each year through the reserve, as follows:

Year Total taxable capital gain (1) Capital gains reserve Taxable capital gains reserve (2) Previous amount of taxable capital gains brought into income (3) Taxable portion of capital gain = (1) - (2) - (3)
1 $600,000 80% $480,000 $0 $120,000
2 $600,000 60% $360,000 $120,000 $120,000
3 $600,000 40% $240,000 $240,000 $120,000
4 $600,000 20% $120,000 $360,000 $120,000
5 $600,000 0% $0 $480,000 $120,000

We discussed other considerations with Dr. Jones such as his upcoming cash flow needs, when he would begin collecting OAS, and, most importantly, the risk of default. Dr. Jones ultimately chose to sell the building in the year immediately following his retirement, and to claim a two-year capital gains reserve, with the first payment being received in January the year following retirement, and the second payment received the January after that. This shortened time frame decreases the risk of default and provided Dr. Jones with adequate security that the second payment will be made. Let’s look at his tax savings using the two-year reserve.

Normal taxes of $13,431 were paid on Dr. Jones’ income of $70,000. Adding half the taxable capital gain of $300,000 to income increased his tax liability $155,043. The difference of $141,612 is attributable to the sale of the building. Multiplying this by two equals a total tax liability of $283,224 on the sale of the building, which is still significantly less than the tax liability of $321,000 if the building were to be sold today and payment received immediately. With some planning, Dr. Jones was able to save $37,776 in taxes by using a 2-year capital gains reserve. The capital gains reserve for Dr. Jones would be calculated as follows:

The capital gains reserve is calculated as the lesser of:

Capital gain divided by the proceeds from disposition, multiplied by the remaining proceeds received after the year-end:

[ $1,200,000 / $2,200,000 ] x [ $2,200,000 - $1,100,000 ] = 0.5455 x $1,100,000 = $600,000 capital gains reserve ($300,000 taxable capital gains reserve)

And

20 per cent of the total capital gain, multiplied by four years:

[ 20 per cent x $1,200,000 ] x [ 4 ] = $960,000 capital gains reserve ($480,000 taxable capital gains reserve)

In the above calculation, the lesser of the two would be selected, so Dr. Jones can elect to us a $600,000 capital gains reserve ($300,000 taxable capital gains reserve)

Dr. Jones would be able to claim the $600,000 reserve in the year of sale, and must recognize $600,000 of capital gains ($300,000 of which would be taxable) in that year. As calculated above, this would help save Dr. Jones $37,776 in taxes, plus allow him to defer paying income tax on $300,000 of taxable capital gains until the following year.

Year Total taxable capital gain (1) Capital gains reserve (2) Previous amount of taxable capital gains brought into income (3) Taxable portion of capital gain = (1) - (2) - (3)
1 $600,000 0.5455 x $1,100,000 x 50% = $300,000 $0 $300,000
2 $600,000 0.5455 x $0 x 50% = $0 $300,000 $300,000

As you can see from the above, with some planning and foresight, there can be significant tax savings from utilizing the capital gains reserve on the sale of capital property. Exceptions to capital property include dispositions to a child of family farming or fishing property, and gifting non-qualified securities to a qualified done.

If you are planning on selling capital property, speak to your Tax Advisor and Portfolio Manager. As a Portfolio Manager, we work closely with our clients’ accountants and provide any requested information. Selling a business or commercial building as you approach retirement may seem daunting, but it shouldn’t be, with your Tax Advisor and Portfolio Manager there to guide you at every step of the way.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138. greenardgroup.com