Capital Gains Reserve
The Capital Gains Reserve is a tool that allows individuals to absorb capital gains over several years. Although it can be used with any buyer-seller relationship, the trust required to accept payment for the real estate over a longer period is significant. This means it is commonly used by families to keep the property in the family.
With the increased capital gain inclusion rate from the 2024 Federal Budget, the use of this tool will significantly help mitigate the increased tax burden when real estate transitions.
Plan Ahead!
It is important to note that this needs to be planned and managed. You can’t just make things up as you go. Everyone’s situation is different, and the outcomes will also be different.
Should the seller die during the period where the capital gains reserve is being used, the remaining balance of the reserve will immediately be brought into income on their final return – negating much of the tax planning that has been prepared.
This discussion only examines the possible use of this tool for families.
How it Works
The Capital Gain Reserve allows you to take into income the amount you were paid each year for the property.
For Qualifying Fishing and Farming properties, it allows you to take the reserve into income for the 9 years following the original sale of the property. For other situations, the limit is 4 years.
This means that you’ll absorb the capital gain over a 10-year period for Qualifying Fishing and Farming properties, and 5 years in other circumstances such as a family cottage, vacation home, or rental property.
The capital gain you include for each year is based on the funds received for the sale in each of those years.
A Quick Example
Let’s say you sell a family cottage and incur a total capital gain of $1,000,000. Under the new capital gain inclusion rates, capital gains tax will be based upon the income inclusion of 50% for the first $250,000 ($125,000 goes into your income), and 66.67% for the remaining amount of capital gains of $750,000 ($500,000 goes into your income).
In other words, you’ll need to include $625,000 in your income, which will be taxed according to your personal rate. At this level of income, you’ll certainly be in the highest marginal tax bracket.
The Capital Gain Reserve allows you to absorb the capital gains over the time you are paid for the sale of the property.
For instance, let’s say you sell the family cottage to one of your children and they agree to pay you $200,000 each year for 5 years. This means that each year you are under the $250,000 limit for 50% inclusion and would have $100,000 included in your income each year. If you had no other income, this would have you about in the middle of the marginal tax brackets.
The overall impact on taxes payable is quite significant due to the difference in capital gains that need to be included in income. Note that this example is extraordinarily simple and your situation will be different from other people’s situations.
Non-Arm’s Length Transactions
When performing transactions that are not at arm’s length, you need to perform them at market value. You can’t “Just sell the cottage to your child for $1.” It won’t matter to the CRA. Since the property was sold below market value, you will still need to pay the capital gains tax based on the market value of the property.
To document this, consider using a realtor familiar with the area to provide a letter of opinion or consider getting an appraisal. It’s important to document what you believe the market value is when performing these non-arm’s length transactions.
Fees vs Tax Trade-off
KATA Accounting can help you plan out your capital gain reserve transaction. Often, hundreds of dollars in fees can result in tens of thousands of dollars in tax savings.
Don’t hesitate to reach out to us if we can help your family!