The Capital Gains Reserve
Have you heard of the capital gains reserve before? If not, today we will be discussing what the capital gains reserve is and how you might utilize it in light of the recent changes to the capital gains inclusion rate.
What is the Capital Gains Reserve?
The capital gains reserve is an effective way to spread out capital gains incurred on an asset over a number of years. For taxpayers who don't receive all the proceeds from the sale of a property in a year of the sale, they may defer the tax associated with the property over as many as 5 years (or 10 years for certain property) using the capital gains reserve. As an example of how this may work:
- Let's say Susan has a cottage she bought many years ago which an adjusted cost basis of $750,000. The cottage is now worth $2,000,000, with an unrealized gain of $1,250,000. If she wants to gift the property to her child, she can enter into an agreement where her child agrees to purchase the property at fair market value, with payments being made over the following 5 years. In this case, the payments can be made through a promissory note, which can be later forgiven in the will. This transaction can create a capital gain reserve and allow Susan to spread out the capital gain of $1,250,000 over the course of 5 years.
What is the benefit to this strategy?
First, we need to recap how the government changes tax rules in the latest newsletter. They increased the capital gains inclusion rate for individuals above $250,000 a year from 50% up to 66.67%. This means your effective tax rate increases when you incur a capital gain higher than $250,000 in any given year. I think you can see where I'm going with this...
In the above example, if Susan were to trigger a capital gain in one year, she would have a capital gain of $1,250,000. Here is how the tax is calculated for someone in the top marginal bracket in Ontario:
- On the first $250,000 capital gain (50% inclusion rate x 53% tax rate) = $66,250 of tax owing.
- On the next $1,000,000 capital gain (66.67% inclusion rate x 53% tax rate) = $353,351 of tax owing.
This means the total tax bill from the sale/gift/transfer of the property would be $387,000.
Consider instead if Susan spread out the capital gain over a five year period. Not only would she benefit from the deferral of tax, but she would be able to ensure that each year she remained under the $250,000 capital gain threshold, thereby keeping the entire capital gain of the sale at the 50% inclusion rate. This would mean the total transaction would result in tax owing of $331,250. ($1,250,000 x 50% inclusion rate x 53% tax rate = $331,250)
This results in a tax savings of $55,750.
While the capital gains reserve is limited mostly to a five year period, if you are transferring a family farm or fishing property, or small business corporation shares, you are able to use a 10 year period in these scenarios.
Hopefully you can see how the capital gains reserve has become a much more effective tool in light of the recent capital gains inclusion rate increases. If you have any questions on how this might apply to you, I would love to hear from you.
Best,
Jon
Jonathan Adomait
Financial Planner | CFP, CIM, B.Eng