When property prices are rising, even just a little, there is almost no better place to keep your money than invested in your own home.
Monthly real estate numbers released Friday show the price of the average Canadian home rose again in September, up almost 10 per cent in the past year. But if and when that trend reverses and prices turn flat or start to fall, the investment advantages of owning a home can take a dramatic turn for the worse. The reason is tax.
At various times in the past, different governments have decided that having citizens own their own homes was a good thing, worth encouraging with tax breaks.
In the U.S., the government decided the way to encourage and reward home ownership was to sweeten the pot by allowing buyers to deduct their interest costs from their taxable income.
That effectively means lower costs in the early stages of home ownership when interest costs are high. In fact, one U.S. home ownership strategy is to pay off a house very slowly, since the interest costs are subsidized by government.
In Canada, the federal government chose a different policy tool to accomplish a similar result.
Instead of giving you a deduction for your payments, the Canadian tax department saves up the entire tax break for when you sell your family home. If during the years you own the property, the value increases, that gain is tax-free.
Earlier this month, Finance Minister Bill Morneau announced changes in the law to try to deny foreign buyers the tax break. Under the old rule, when you sold your principal residence you didn’t even have to mention it to the tax department.
Just as U.S. interest tax deductions affect how people buy and pay off their houses, the Canadian policy has its own consequences.
When property prices are on the way up, rising more than 20 per cent in a year as they have in Toronto and Vancouver, for tax purposes, there is almost no better place to keep your money.
In fact, a good tax strategy might be to buy a house with the biggest mortgage you can afford the payments on. The law can also make it a good strategy to up-size when you can afford it.
The math is clear. If you put down $100,000 on a million-dollar home, and get a $900,000 mortgage for the rest, you own 10 per cent of the house while the bank owns 90 per cent. But if that $1 million home goes up in value by 20 per cent, the bank doesn’t get a share of that increase — all of the capital gains are yours.
Sell, and you’ve just turned a $100,000 investment into $300,000, tax-free.
That’s also why there are so many contractors who buy a house and keep it for a year while they fix it up for resale. Not only do they get the standard capital gains that other sellers get, if they do a good job on the renovation, they get an added premium, and by claiming the house as a principal residence, all the money they earn is free of tax.
The capital gains tax also affects elderly homeowners. While house prices are rising, retired people, especially the well-heeled, have little reason to sell their houses and downsize. Capital gains on their houses are tax-free, but the income from the proceeds of selling a house that are invested outside tax shelters (such as retirement savings plans, tax-free savings accounts and registered retirement income funds) is fully taxable.
Canadian house prices have continued to increase over the very long term. With population continuing to rise strongly, that’s unlikely to change over the long term.
That means people who buy a house with the intent of raising a family will very likely be able to take advantage of the federal capital gains break on principal residences even if real estate goes off the boil for a few years.
As I’ve mentioned in the past, when my family came back to Canada at the end of the 1990s, we visited friends who told us their home had just climbed back to the value they had purchased it for 13 years before.
If you own a home, declining house prices are bad for your finances in any case. But the capital gains tax break makes it even worse.
For some potential homebuyers, the effect of a medium-term slide in property prices and its impact on the capital gains advantage could alter the calculus for thinking of a home as an investment.
In such a case, potential short-term buyers might be wiser to rent. Flippers will have to recalculate their profit margins. Up-sizing may lose its advantage. Retired people might be better off selling and investing the cash, because income taxed is better than no income at all.
And unlike other investments that can be claimed as a loss when they fall in value, a house cannot. In other words, capital gains on your principal residence are sheltered from tax. But so is a capital loss.
It’s hard to be sure to exactly what degree capital gains tax breaks affect people’s decision to use their principal residence as an investment. But it would seem that during a period of declining prices, that tax break would have the effect of further reducing demand for houses.
Source: Don Pittis, CBC News