The controversial increase to the capital gains inclusion rate (CGIR) to two-thirds from half, effective June 25, 2024, has created a new tax reality for Canadian investors. While the window for major dispositions has closed, taxpayers still have options to optimize their tax positions. One such strategy, often overlooked but now more valuable than ever, is the capital gains reserve.
Understanding the Capital Gains Reserve
The capital gains reserve allows Canadians to spread the reporting of capital gains over multiple years when they don't receive the full payment for a capital property in the year of sale. This provision can be claimed for up to five years in most cases (four years following the year of disposition), with a nine-year option available for certain transfers to children and gifts to qualified donees. The capital gains reserve is particularly beneficial for transactions involving real estate sales with deferred payments, business sales with earn-out provisions, and large asset dispositions with extended payment terms.
The reserve is calculated by subtracting the adjusted cost base and selling expenses from the property's sale price, minus the reserve amount claimed for the year. The resulting number represents the portion of the capital gain that must be reported on your tax return for the year of sale. As a general rule, taxpayers must claim at least 20% of their gain annually through the capital gains reserve period (10% for certain property).
Leveraging the $250,000 Threshold
Under the new CGIR rules, individuals can still benefit from the lower 50% rate on up to $250,000 of capital gains annually. By using a capital gains reserve, it may be possible to keep gains below this threshold each year.
For example, when transferring a family cottage to children using a promissory note, you can stagger the gain over up to five years. This strategy can be more tax-efficient than gifting the property outright, which would trigger a larger immediate tax bill.
Timing Considerations
For dispositions before June 25, 2024, any portion of a capital gain brought out of reserve in 2024 will still be subject to the 50% inclusion rate. However, starting in 2025, amounts above the $250,000 threshold will be subject to the new two-thirds rate. This creates an interesting planning opportunity for those with existing reserves. It may be beneficial to report more of a significant capital gain in 2024 while the lower rate still applies across the board.
According to the CRA, when you bring a capital gain out of reserve in a later year, it is taxed at the rate applicable for that year. For instance, if you realized a gain in 2023 using a reserve, any portion of that gain reported in 2025 would be taxed at the lower 50% rate for amounts under $250,000, and the excess at two-thirds.
Moreover, for tax years including June 25, 2024, the capital gain brought out of reserve will be taxed based on the rate effective on the first day of the tax year, which is January 1 for individuals (50%). However, for dispositions made after June 25 and beyond (Period 2), with a gain greater than $250,000, the portion above this threshold will be taxed at the higher two-thirds rate.
Anyone currently in the middle of a multi-year capital gains reserve needs to decide whether to continue deferring the gain past 2024. If the capital gain from the sale is substantial, it might be advantageous to bring the remaining gain out of reserve this year.
The good news is that there is still plenty of time to reach a decision before the tax return deadline for 2024.
Corporations and Trusts
All taxpayers — individuals, trusts, and corporations — may claim a capital gains reserve. While corporations and trusts don't have access to the $250,000 threshold, they can still benefit from the tax deferral. This allows for better matching of tax payments with the receipt of sale proceeds, which can be crucial for cash flow management.
BOTTOM LINE
Given the new tax landscape, it's important to review existing capital gains reserves and assess whether accelerating gain recognition in 2024 could be beneficial. Additional strategies to consider include selling portfolio "winners" at year-end to stay under the $250,000 gain threshold and realizing capital gains annually for older individuals rather than facing a large tax bill on death.
As always, given the complexity of tax laws and the unique circumstances of each individual and family, consulting with qualified tax advisors is crucial to developing a personalized strategy that aligns with your risk tolerance and financial goals. If you have any quips or queries, please get in touch.