Normally, you include in income the full taxable capital gain in the year in which the proceeds are received or receivable by you.
However, if some or all of the proceeds of disposition are due after the year of sale, you can normally claim a capital gain reserve, which effectively spreads out the inclusion over up to 5 years in which you receive the proceeds.
The maximum allowable reserve in a year is the lesser of two amounts.
The first amount is sometimes called the “reasonable portion” amount, because it is the portion of the capital gain that can reasonably relate to the proceeds of disposition that are due after the year. Typically, this amount is determined by multiplying the gain by the fraction equal to: proceeds due after year / total proceeds. (An example is provided below.)
The second amount is sometimes called the formula amount because it is subject to a specific numerical formula. Basically, the amount is a fraction multiplied by the gain. In the year of sale (year 1) the fraction is 4/5ths, and in subsequent years 2 through 4, assuming the reserve still applies, the fraction is 3/5ths, 2/5ths, and 1/5th, respectively.
Since the reserve is based on the lesser of the two amounts, a couple of things become apparent. Because of the first amount, the reserve is not available in a year if no further proceeds are due after that year. That obviously makes sense, since it means you will have received all of the proceeds by that year. Because of the second amount, which only allows a reserve up to year 4, you will have to recognize any remaining gain in year 5 even if some proceeds have not yet been received.
If you claim a reserve in one year, you must add that amount back into your income in the next year, at which point you may be able to claim a further reserve, subject to the above rules. (If you did not add back the reserve, that portion of the gain would never be reported, which explains the reason for the add-back.)