Canadian Tax Journal, Vol. 57, No. 3, 2009

Transcription

canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 3, 460 - 88
Capital Gains Rollovers and the
Two‑Sector Rental Housing Market:
A Simulation Study of Toronto
Marion Steele*
Précis
Dans les villes où le prix des maisons est en forte hausse, on a constaté depuis quelques
décennies une réduction des projets de construction d’immeubles locatifs à logements
multiples en même temps qu’une forte hausse des investissements dans les
condominiums destinés à la location et les autres petits immeubles locatifs. Ce dernier
type d’investissement est très répandu : près de 8 pour cent des contribuables
particuliers ayant un revenu cotisé à plus de 40 000 $ a déclaré un revenu net de location
ou une perte de location pour l’année d’imposition 2005. Les motivations différentes des
investisseurs dans chacun des deux secteurs des immeubles à logements multiples et des
condominiums correspondent à la double nature du rendement : les revenus de location
et les gains en capital. Les données de l’étude montrent que les gains en capital
représentent le principal attrait des condominiums, une qualité qui n’est pas sans rapport
avec leur facilité de vente sur le marché soit des investisseurs ou des propriétaires
occupants. On peut considérer que cette particularité vaut approximativement entre
36 000 $ et 73 000 $, soit la différence de prix d’une unité d’habitation type de deux
chambres qui a été constatée entre le secteur des immeubles locatifs à logements
multiples et celui des condominiums dans le marché de Toronto en 2006.
Les simulations présentées dans l’article montrent que la valeur actualisée nette des
recettes d’impôt pour le fisc que représente un immeuble résidentiel locatif à Toronto qui
serait détenu sur une période de 20 ans est supérieure dans le marché des immeubles
d’habitation à logements multiples que dans le secteur des condominiums, lorsque les
gains en capital sont modestes. En comparant des situations plus caractéristiques de
chaque secteur de manière à présumer que les investissements dans le secteur des
* Of the Department of Economics, University of Guelph, and Cities Centre, University of
Toronto (e-mail: [email protected]). I am grateful to the editor, Alan Macnaughton,
and two anonymous, thoughtful referees for comments, suggestions, and corrections that have
greatly strengthened this article; to François Des Rosiers, Laval, for providing me with his
nicely setup spreadsheets, the foundation of the spreadsheets used in this article; to Miana
Plesca for her help with software; and to Mitchell Stein, Bev Dahlby, and other participants of
the Deloitte Tax Policy Research Symposium for useful comments. I am also indebted to Vince
Brescia, of the Federation of Rental-Housing Providers of Ontario for his insightful comments.
The usual caveat that none of these people is responsible for errors of fact or interpretation is
especially important here because my views and those of Vince Brescia differ in many respects.
460 capital gains rollovers and the two-sector rental housing market n 461
condominiums sont à court terme et que les gains en capital sont importants, les
recettes d’impôt provenant du secteur des condominiums restent inférieures, en raison
d’importantes pertes de location au cours de la période de détention. Si, contrairement à
ce qu’on pouvait s’attendre, le prix des maisons devait diminuer d’une façon importante,
la perte de recettes fiscales enregistrée préalablement ne sera pas compensée par des
recettes fiscales plus élevées à la vente de l’unité d’habitation.
En cas de roulement de gains en capital, les simulations montrent que les recettes
fiscales générées par les immeubles locatifs à logements multiples à Toronto
demeureront importantes. Toutefois, dans le contexte d’un enthousiasme irrationnel
généralisé à l’égard du secteur de l’habitation, le marché des condominiums en location
entraînera de lourdes pertes de recettes fiscales.
L’article traite des désavantages que présentent les petits immeubles locatifs pour
les marchés des capitaux et de l’habitation ainsi que pour les locataires. L’auteur conclut
que le roulement de gains en capital serait tout particulièrement problématique pour ce
secteur locatif et il suggère d’approfondir les possibilités offertes par une disposition
relative à la capitalisation restreinte sur les immeubles locatifs.
Abstract
Over the last few decades, in cities with rapidly rising house prices, there has been little
construction of multi-unit rental apartment buildings, while there has been major
investment in rental condominiums and other small rental properties. This kind of
investment is widespread: nearly 8 percent of individual tax filers with an assessed
income exceeding $40,000 declared net rental income or a rental loss in the 2005 tax
year. Investment motivation in both the multi-unit rental and condominium sectors
reflects the two-faceted nature of return: rental income and capital gains. Evidence is
adduced that capital gains are the dominant attraction of condominiums, a matter
related to the ease of selling condominiums in either the investor or the homeowner
market. This characteristic is estimated to account for approximately $36,000 to $73,000
of the difference between the price per unit of a typical resale two-bedroom apartment in
the multi-unit rental and the condominium sectors in Toronto in 2006.
Simulations in the article show that the net present value to government of the
income tax revenue yielded by a rental residential property in Toronto that is held for 20
years is greater in the multi-unit than in the condominium sector, when there are modest
capital gains. Comparing situations that are more typical of each sector by assuming that
investments in the condominium sector are short-term and capital gains are large, the
tax revenue from condominiums remains less, because of large rental losses during the
holding period. If, contrary to expectations, housing prices fall, the earlier tax revenue
loss will not be offset by large streams of revenue when the property is sold.
If there is a capital gains rollover, the simulations show that the tax revenue generated
by multi-unit rental properties in Toronto will remain substantial. However, under
conditions of irrational exuberance in the housing market, rental condominiums will
produce large tax revenue losses.
The article discusses disadvantages of small rental properties for financial and
housing markets and for tenants. It concludes that a capital gains rollover would be
particularly problematic for this rental sector and suggests that a thin capitalization rule
for rental property should be investigated.
Keywords: capital gains n rollovers n investors n prices n housing n condominiums
462 n canadian tax journal / revue fiscale canadienne
(2009) vol. 57, n o 3
Contents
Introduction
Two Sectors in the Rental Housing Market
Distinguishing Characteristics
The Income Tax System and Motivations for Investment in the Two Sectors
Leverage in the Two Sectors: The Tax Incentive and Constraints
Income Taxes Paid by Investments in the Multi-Unit Rental and Condominium Sectors
Modelling and Assumptions
Results for the Multi-Unit Rental Residential Sector
Results for the Rental Condominium Sector in a Rational Market
Results for the Rental Condominium Sector: Irrationally Exuberant Market
Returns and Taxes Paid If the Market Remains Irrationally Exuberant
Returns and Taxes Paid If the Period of Irrational Exuberance Is Limited
A Legal Impediment: An Income Gain Rather Than a Capital Gain?
The Effects of Tax Forgiveness on Return and Taxes Paid: Differential Effects on
the Multi-Unit and Condominium Residential Sectors
Evidence of the Importance of Lock-In for Rental Residential Investment
Possible Implications of Highly Levered Investment in Small Rental Properties
for Housing and Finance Markets
Conclusion
Appendix
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Introduc tion
This article analyzes the consequences for the rental housing market of a capital
gains rollover for reinvested proceeds. Such a tax change has been frequently proposed1 as a remedy for the virtual absence of housing starts in the rental market—
that is, multi-unit residential buildings intended for rental occupancy. A rollover was
proposed by the Conservative Party of Canada in 2006 and continues to be advocated by business groups.2 Under this proposal, capital gains taxes would be eliminated
for individual taxpayers if real estate or other assets are sold and the proceeds are
reinvested within six months of the sale. The article argues that this rollover would
greatly reduce the taxes paid by the small property rental sector, as well as increase
an important distortion in the rental housing market.
The distortion in the rental market results from the fact that the dominant
source of new supply is non-traditional—condominium units, duplexes, converted
houses, and other small properties—rather than traditional—multi-unit buildings
constructed for the purpose of rental. For years, the virtual absence of the latter
1 Ontario, Ministry of Municipal Affairs and Housing, Creating a Positive Climate for Rental Housing
Development Through Tax and Mortgage Insurance Reforms, Second Report of the Housing Supply
Working Group (Toronto: Ministry of Municipal Affairs and Housing, 2002).
2 Steven Chase, “Harper’s Capital Gain Promise Fades from View,” Globe and Mail, February 11,
2008.
capital gains rollovers and the two-sector rental housing market n 463
source of new supply has been a cause of concern,3 while only incidental attention
has been paid to the former source. This article analyzes both sources. Under reasonable assumptions, in a high capital gains city, specifically Toronto, income taxes
paid by investors in the two sectors are very different. They are higher in the multiunit than in the small property sector when the real estate market is irrationally exuberant and holding periods are short. This difference arises fundamentally because of
the differing roles that capital gains are expected to play in the two sectors.
The article continues with a discussion about the two-sector rental housing
market—its distinguishing characteristics, prices and rents, investment motivations,
and leverage opportunities. Aggressive lending in recent years has made it easier to
obtain the high leverage4 that the tax system rewards, but that may harm the financial system. This sort of lending tends to be concentrated in rapidly inflating markets,
where irrationally exuberant investments are motivated by expectations of high
capital gains.
To demonstrate the tax effects of the bifurcation of the rental sector, assumptions
are set out for the simulation of operating results in the two sectors, for both short
and long holding periods in a rational market. Assumptions are also set out for an
irrationally exuberant market in the case of the small property sector. The discussion of results focuses on taxes paid during and at the end of the holding periods.
Next, the simulation results of tax forgiveness on rollover are discussed. The article
then moves to a larger arena: consideration is given to several implications for both
the housing and the finance markets of exuberant investment in small properties, as
well as the associated high leverage and aggressive lending.
T w o S e c t o r s i n t h e R e n ta l
Housing Market
As noted in the introduction, the rental housing market has both a multi-unit allrental building sector and a small property sector. In the Toronto census metropolitan
area, the first sector amounted to about 300,000 units in 2006, somewhat more than
half of the total number of rental units: 584,125.5 In Canada as a whole, multi-unit
rental is dominant in only a few areas. This situation is not unique to Canada: it is
3 Ontario, Ministry of Municipal Affairs and Housing, supra note 1.
4 Andrey Pavlov and Susan Wachter, “Subprime Lending and House Price Volatility,” University
of Pennsylvania Law School Institute for Law and Economics Research Paper no. 08-33
(Philadelphia: University of Pennsylvania, 2008).
5 The first number is inferred from the fact that in the fall of 2006, Canada Mortgage and
Housing Corporation (CMHC) identified for its rental unit universe 306,544 apartments in
private rental buildings of three units or more. See Canada Mortgage and Housing Corporation,
Rental Market Report: Toronto CMA (Ottawa: CMHC, 2006) (online: http://www.cmhc-schl.gc.ca/
odpub/esub/64459/64459_2006_A01.pdf ). The second number represents total renting
households (including non-private housing), from the 2006 census, Statistics Canada, 2006
Community Profiles—Census Metropolitan Area/Census Agglomeration—Toronto (CMA), catalogue
number 97-554-x2006019.
(2009) vol. 57, n o 3
also true in the United States.6 In Australia and the United Kingdom, there is little
rental other than that involving small properties.7
Distinguishing Characteristics
There are two (linked) distinguishing characteristics of small properties. The first is
tenure elasticity. Multi-unit rentals are more or less firmly fixed in the rental market,8
while small properties are not so fixed; indeed, they frequently switch between rental
and home ownership.9 A rental condominium may be sold to an owner-occupier, or
the reverse may occur. Similarly, a rental duplex may be sold to an owner-occupier
who lives in one unit and continues to rent out the other one.
The second crucial characteristic of small properties is that those who invest in
them tend to pay more per unit than investors who buy units wholesale, regardless
of whether they purchase apartment buildings or buy into real estate investment
trusts (reits). The premium arises in part because of the absence of economies of
scale in the transaction process, but it also stems from the dual market for small
properties. An investor knows that when a unit is sold, the buyer may be either an
investor or an owner-occupier. A rental condominium or other small property fetches
the higher of the prices bid by these two differently motivated buyers. In contrast, the
multi-unit investor has effectively no option but to sell to another investor.
Prices and rents in these two markets reflect these characteristics. In the fall of
2006 in Toronto, the price of a two-bedroom apartment in an existing multi-unit
rental building was typically under $100,000; for the purpose of calculations, I have
set it at $90,000.10 This was less than half the price of a new multi-unit rental.11 In
6 Amy S. Bogdon and David C. Ling, “The Effects of Property, Owner, Location, and Tenant
Characteristics on Multifamily Profitability” (1998) vol. 9, no. 2 Journal of Housing Research 285-316.
7 Rayna M. Brown, Gregory Schwann, and Callum Scott, “Personal Residential Real Estate
Investment in Australia: Investor Characteristics and Investment Parameters” (2008) vol. 36,
no. 1 Real Estate Economics 139-73; Kathleen Scanlon, with Christine Whitehead, The Profile
and Intentions of Buy-To-Let Investors (London: The Council of Mortgage Lenders, 2005)
(online: http://www.cml.org.uk/cml/publications/research).
8 In principle, a rental building may be converted into condominiums, an equity co-operative, or
a co-share, but many municipalities put obstacles in the way, and in any case, transaction costs
in conversions are steep enough to constitute a major barrier.
9 Marion Steele, “Conversions, Condominiums and Capital Gains: The Transformation of the
Ontario Rental Housing Market” (1993) vol. 30, no. 1 Urban Studies 103-26; Vince Brescia,
Conversions and Demolitions Policies in Ontario: Myths and Realities (Toronto: Federation of
Rental-Housing Providers of Ontario, 2005).
10 I was informed by an employee of a Canadian REIT in the fall of 2005 that the REIT would
not pay more than $80,000 to $90,000 per unit in Toronto for a building; multi-unit buildings
usually include a mixture of one- and two-bedroom units, as well as a few bachelor units. This
value is consistent with other values that I found, mainly on Web sales sites, such as www.icx.ca
and example transactions posted on www.Realnet.ca. (The example posted August 19, 2008 was
a Scarborough building, consisting mainly of two-bedroom apartments, listed at $73,421 per unit.)
11 The purchase price of a new apartment building, expressed in per-apartment terms, for an
apartment that is 850 square feet, has two bedrooms, is of average quality, and has standard
Toronto in April 2007, the median listing price for a two-bedroom condominium
unit was $225,000.12 Thus, the median price of an existing small property was about
$135,000 higher than the price of a unit in an existing apartment building.
The difference between the price of existing multi-unit buildings and condominiums is the result of three factors: (1) the economies of scale when selling
“wholesale” rather than “retail,” (2) the greater age of existing multi-unit buildings,
and (3) the value of being able to buy and sell an individual unit. The calculation to
determine the value of these three components is illustrated in table 1. To obtain an
estimate of component (2), assume physical depreciation of 1 percent per year, a
rate implicitly used in a well-known real estate textbook.13 Assume a typical age of
30 years for an existing Toronto multi-unit rental building. The purchase price,
new, of this property is estimated for 2006 at $204,000, with the value of land accounting for $47,000 of this amount.14 Depreciating the building at a rate of 1 percent gives a property value at 30 years of age of about $163,000.
For a comparison with the price of existing Toronto condominiums, assume the
same depreciation rate, but an average age of only 10 years; this gives an estimated
wholesale price for existing condominiums of about $189,000. The implication is that
the difference in age accounts for $26,000 ($189,000 – $163,000) of the difference
in value between a condominium and a multi-unit rental. The markup of condomin
iums over wholesale because of a lack of economies of scale in marketing and other
transactions costs is implied to account for about $36,000 ($225,000 − $189,000) or
16 percent. This leaves the residual $73,000 ($163,000 − $90,000) as an estimate of
the value of factor (3), the ability of investors to own condominiums individually.15
An alternative estimate of factor (3), obtained by comparing rents—$1,067 for
units in multi-unit buildings and $1,487 for condominiums—is $36,000.16 Thus, I
estimate that the value to investors of the ability to sell units individually in either
features and amenities, is estimated at $204,000; the land value included in this amount is
$47,000, using Ernst & Young numbers extrapolated to 2006. See Ernst & Young, Comparative
Real Estate Finance Analysis (Ontario Ministry of Municipal Affairs and Housing, Housing Policy
Branch, Housing Supply Working Group, 2001). For details, see Marion Steele, “The WholesaleRetail Rental Housing Split: Irrational Exuberance in Housing Markets and Effective Tax
Treatment,” August 2008, at http://www.uoguelph.ca/~msteele1/msteele.htm.
12 This was the median price in April 2007 of over 3,000 two-bedroom condominium units
posted on the multiple listing service (MLS) site (online: http://www.mls.ca), located in the
Greater Toronto Area.
13 Norman G. Miller and David M. Geltner, Commercial Real Estate Analysis and Investments
(Upper Saddle River, NJ: Prentice-Hall, 2001).
14 Estimated using Ernst & Young numbers, supra note 11.
15 In other words, the market value of a 30-year-old building is far below the depreciated cost of a
new building, as long as it is a multi-unit rental building rather than a condominium.
16 The rents are for two-bedroom apartments, from CMHC’s Rental Survey, fall 2006, for
conventional and condominium units: see Canada Mortgage and Housing Corporation,
“National Rental Vacancy Rate Inches Down to 2.6 Per Cent,” News Release, December 14,
2006. For details of the estimate of $36,000, see Steele, supra note 11.
Market value, 10 years old . . . . . . . . . . . . . . . . . . . . . . . . . (markup to cover marketing costs)
$204,000
$189,000
$163,000
$90,000
Cost-based value, new building plus land . . . . . . . . . . .
(depreciation of building at rate
of 1% of declining balance)
Cost-based value if 10 years old . . . . . . . . . . . . . . . . . . .
(depreciation of building at rate
of 1% of declining balance)
Cost-based value if 30 years old . . . . . . . . . . . . . . . . . . .
Market value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$90,000
$163,000
$189,000
$225,000
Note: These estimates of components should be taken as illustrative, giving only orders of magnitude. The basis for the estimates of the cost of new units
and the breakdown into land and building costs is given in the text, as is the basis for the estimate of the market value of an average condominium unit and
that of an average unit in a multi-unit rental building. The average ages assumed here are based on a crude estimate of the average age of the
condominium stock and the multi-unit rental stock in Toronto.
Market value at 30 years if sold as multi-unit rental instead of wholesale condominium . . . . . . . . . . . . . . . . . Value at 30 years if sold wholesale but registered as a
condominium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($73,000 discount for inability of
investor to own an individual unit that can be
sold in the owner-occupier market)
Value at 10 years if sold wholesale but registered as a
condominium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (depreciation of building at of rate
1% of declining balance)
Condominium unit
Unit in multi-unit rental building
Table 1 Schematic Reconciliation of the Difference Between the Price Per Two-Bedroom Apartment for a Unit in
a Multi-Unit Rental Building and in a Two-Bedroom Condominium Apartment, Toronto, 2006
(2009) vol. 57, n o 3
the renter or home owner market is in the range of $36,000 to $73,000. This estimate clarifies the reason why for many years there has been a virtual absence of
construction of multi-unit rental in Toronto, demolitions of some older buildings,
and pressure for conversion to condominiums.
What do price-to-rent ratios tell us about the motivation of investors? The rents
and prices provided above imply ratios of 7.0 and 12.6 respectively.17 Following
Capozza and Seguin,18 these ratios reflect far higher expectations of capital gains in
the condominium than in the multi-unit rental building market.19 These expectations are grounded in the estimated annual real rate of house price increase of
slightly more than 2 percent in Toronto over the 30 years ending in 2002,20 and
much higher rates over the last decade. The observed price-to-rent ratio for
Toronto condominiums is not surprising if investors extrapolate from the past.
The marked difference in expectations of capital gains between the two sectors
of the rental market makes it important to examine the interaction between investment motivation and the income tax system.
The Income Tax System and Motivations
for Investment in the Two Sectors
In real estate, as in the stock market, total return consists of two components: net
(rental) income and capital gains. Rental income is taxed annually. However, capital
gains are not taxed as they accrue, but when a property is sold, and only 50 percent
of a capital gain is included in income.21 The light taxation of capital gains relative to
rental income strengthens the lure of the small property sector. The low price-torent ratio in the multi-unit sector indicates that lightly taxed capital gains are not an
important lure there. Many multi-unit investors want a stable annual cash flow, and
17 The first price is $90,000 for a multi-unit rental; the second price is $225,000 for a
condominium, and annual rents are respectively 12 × $1,067 and 12 × $1,487.
18 Dennis R. Capozza and Paul J. Seguin, “Expectations, Efficiency, and Euphoria in the Housing
Market” (1996) vol. 26, no. 3 Regional Science & Urban Economics 369-86.
19 The contrast may also be put in terms of the cap rate (the ratio of net operating income to price).
Using the assumptions in table 3, this is 9.0 percent for the wholesale unit and 5.3 percent for
the condominium unit. If the capital expenditure every five years were rolled into operating
costs, the cap rates would be 8.2 percent and 4.4 percent respectively. If an adjustment were
made for the fact that capital expenditure cannot be entirely written off in the year in which it
is incurred, the cap rates would be slightly lower.
20 Canada Mortgage and Housing Corporation, “Estimates of the Private and Societal Costs and
Benefits of Homeownership in Selected Canadian Cities,” Research Highlight, Socio-Economic
Series no. 06-005 (Ottawa: CMHC, 2006).
21 A more generous treatment applies in the United States (see Miller and Geltner, supra note 13)
and a less generous one (in some circumstances) applies in Australia, where total real capital
gains are included in income. See Gavin A. Wood and Yong Tu, “Are There Investor Clienteles
in Rental Housing?” (2004) vol. 32, no. 3 Real Estate Economics 413-36.
(2009) vol. 57, n o 3
many owners are reits,22 whose units are frequently held by retirees. Furthermore,
the trust structure does not allow unitholders to deduct losses, which tend to be associated, in the early years in which an investment is held, with properties that are
expected to yield large capital gains.
Theory predicts that it is investors with a high tax rate who will be particularly
attracted to an investment with a dominant capital gains component. Wood and
Tu23 econometrically establish for Australia that individual investors in high tax
brackets tend to be invested in properties, such as condominiums, with the high
price-to-rent ratios that anticipate high capital gains.
Leverage in the Two Sectors: The Tax Incentive and Constraints
The Canadian tax system rewards leverage—that is, a low equity-to-value ratio—
because interest expense is fully deductible, and a net rental loss produced by high
debt is deductible against employment income. Such a loss is the likely consequence
of high leverage combined with an expectation of high capital gains. It is only because of this expectation that the investor in a small property is willing to pay a price
that is high in relation to the going rent. But the high price, together with a low
down payment, implies that interest costs on a mortgage will be high and tend to
create a net rental loss.
There are a number of constraints on a strategy of high leverage, high tax-deductible
rental losses, and high capital gains. The first such constraint is a legal one: investors
are not permitted to deduct a loss created or increased by the capital cost allowance
(cca) against their employment income. But there is no such prohibition if a loss
arises because of high interest expense,24 and these losses are valuable to taxpayers
with high incomes from self-employment, for example. Indeed, there is a relatively
high incidence of rental holdings among self-employed professionals: in the 2006
tax year, 10.2 percent of tax filers with professional income as a major source of income reported net rental income.25 There is also no restriction on the deduction of
22 Boardwalk REIT, for example, reports that it owns nearly 37,000 units in Canada. See Boardwalk
Real Estate Investment Trust, “About Us-Boardwalk REIT” (online: http://www.boardwalkreit
.com/AboutUs/ ).
23 Supra note 21.
24 This contrasts with the situation in the United States, where there is no special treatment of
losses created by depreciation allowance; there is, however, a prohibition against deduction
of any loss on rental properties—a passive loss—against employment income if the taxpayer has
an income exceeding US $150,000, with the restriction phased in starting at US $100,000. In
addition, the maximum deduction against employment income is $25,000 for those allowed to
deduct any loss. Thus, the US treatment is more generous to taxpayers with employment
income of under US $100,000, as long as the loss is not extremely large, and less generous to
those with employment income over US $150,000.
25 Calculated from Canada Revenue Agency, Final Statistics, 2008 edition (2006 tax year), interim
table 3 (online: http://www.cra-arc.gc.ca/gncy/stts/gb06/pst/ntrm/pdf/table3-eng.pdf ). In a
non-random survey, Arcturus Solutions found 39 percent of the landlords that it surveyed were
a loss (including one created by the cca) against the net rental income from another
property. Therefore, an individual accumulating property over time is apt to be able
to deduct the net rental loss of recent purchases. Furthermore, recent court decisions
have dealt a death blow to the previous requirement of a reasonable expectation of
profit.26
A second constraint is the economic one: higher leveraging adds to risk. There
is a tradeoff between risk and return, and risk-averse investors generally do not make
highly leveraged investments. But investors may assess risks unrealistically, especially in periods of rapidly rising property prices and irrational exuberance.
The third constraint is institutional. Banks and other lenders may be unwilling
to lend an investor as much as he or she wishes to borrow because of their assessment of excessive risk. Indeed De Meza and Southey27 have shown that there is a
theoretical case that entrepreneurs, including investors in real estate, tend to be irrationally optimistic. However, borrowers who purchase multi-unit rentals are
reined in by the general use of guidelines, such as a minimum debt-coverage ratio
(dcr: net operating income as a ratio of the mortgage payment) that borrowers
must meet; a dcr of at least 1.20 is a common requirement.28
In the case of investors in small properties, constraints are fundamentally different.
Crucially, there was no need for a positive cash flow in July 2008. Canada Mortgage
and Housing Corporation’s (cmhc’s) main private competitor, Genworth Financial,
in July 2008 offered mortgage insurance for loans on small properties on terms that
required little cash up front, with emphasis on the income of the borrower, not the
property. High earnings could offset negative rental cash flow,29 and this loan insurance was open to an investor with other rental properties. cmhc requirements were
essentially the same, although some elements were less rigorous.30 These criteria
meant, for example, that a newly qualified surgeon living in rental accommodation
self-employed, and it is possible that a few of these were professionals. See Arcturus Solutions,
Individual Landlord Survey (Ottawa: CMHC, 2005) (online: http://www.cmhc-schl.gc.ca/odpub/
pdf/64857.pdf ).
26 I am indebted to Professor Jinyan Li, of Osgoode Hall Law School, for this information
(personal communication, summer 2007).
27 David De Meza and Clive Southey, “The Borrower’s Curse: Optimism, Finance and
Entrepreneurship” (1996) vol. 106, no. 435 Economic Journal 375-86.
28 For example, Canadian Mortgage Capital Corporation usually requires a ratio of 1.20. See
Canada Mortgage Capital Corporation, “Multi-Residential Mortgages” (online: http://www
.cmcapitalcorp.com/v2/mortgage/multiresidential.asp).
29 Genworth’s qualification formula for investors in July 2008 was a generously amended version of
that for home purchasers; the formula was provided in July 2008 on Genworth’s Web site:
http://www.genworth.ca/mi/eng/product_solutions/investment_property.asp (qualification
requirements were more demanding in September 2009). Investors were required to have a
credit score of 660 or better.
30 Canada Mortgage and Housing Corporation, “Homeownership Products,” July 2008 (online:
http://www.cmhc.ca/en/hoficlincl/moloin/hopr/index.cfm).
(2009) vol. 57, n o 3
and having no savings could have obtained a variable-rate mortgage for investment
in a few small properties.
An alternative route for avoiding the dcr requirement is open to investors who
own a home with substantial equity. An investor is able to borrow to buy an investment
property with, in effect, a zero down payment. To do this, the investor establishes a
personal line of credit (plc) secured by a mortgage on the home, unlocking noquestions-asked access to as much as several hundred thousand dollars. Qualifying
for a large plc requires that potential interest payments be sufficiently low relative
to the investor’s personal income. The plc provides a route to financing 100 percent of the property value with debt.31
There is evidence that households have been using the plc route. Table 2 shows
that homeowners who own real estate besides their own home are far more likely to
have a large plc debt than other homeowners of the same income level: 5.9 percent
of homeowners holding real estate worth over $200,000 had plc debt over
$100,000. Direct survey evidence on financing is not available for Canada, but a
survey of uk owners of small rental properties found that remortgaging other rental
properties and homes, as well as drawing on savings, provided the dominant source
of down payment.32
I n co m e Ta x e s Pa i d b y I n v e s t m e n t s
i n t h e M u lt i - U n i t R e n ta l a n d
Co n d o m i n i u m S e c t o r s
Modelling and Assumptions
In this section, taxes and investment returns are estimated for both long and short
holding periods for typical Toronto investments in the two rental housing sectors.
It will become apparent that current tax treatment usually rewards rental condominiums relative to multi-unit rental. It especially rewards condominiums when
investment is short-term and housing markets are irrationally exuberant. A capital
gains rollover would exacerbate this problem.
The rational assumption refers to expectations that are consistent with medium
or long-run equilibrium in the models of Fallis and Smith33 and Hendershott et al.34
This assumption requires that all prices but the price of land rise at the same rate,
31 The same investor could join a partnership purchasing wholesale units and finance his or her
portion of the down payment from a PLC. However, there are principal-agent problems in
these partnership arrangements, which makes it appealing for individuals to own one or two
units solely, rather than 50 or 100 units jointly with many partners.
32 Scanlon and Whitehead, supra note 7.
33 George Fallis and Lawrence B. Smith, “Tax Reform and Residential Real Estate,” in Jack
Mintz and John Whalley, eds., The Economic Impacts of Tax Reform, Canadian Tax Paper no. 84
(Toronto: Canadian Tax Foundation, 1989), 336-65.
34 Patric H. Hendershott, James R. Follain, and David C. Ling, “Effects on Real Estate,” in
Joseph A. Pechman, ed., Tax Reform and the U.S. Economy (Washington, DC: The Brookings
Institution, 1987).
Table 2 Incidence of Personal Line-of-Credit (PLC) Debt
by Value of Other Real Estate
Size of PLC Debt
Value of other real estate
$50,000 to
$100,000 (%)
$50,000 to $100,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 to $199,999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 and over . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5
2.0
3.8
Over
$100,000 (%)
1.1
2.3
5.9a
a Means
that 5.9 percent of families with other real estate worth $200,000 or more have over
$100,000 PLC debt. Sample: families with major income earner age 25 to 64.
Source: Estimates were computed from Statistics Canada’s public use micro datafile, Survey of
Financial Security, 1999 using its universal weights.
so that the real price of buildings is constant, and real rents rise only if the real price
of land does; this assumption about the price of buildings and rents is also used in
Miller and Geltner.35 Tax changes are not capitalized in the long run in these models because it is assumed that in the long run new buildings are elastically supplied
at the construction price. The pre-2009 situation in Toronto and other inflating
Canadian cities, described earlier in this article, in which new private-sector multiunit rental buildings are rare, is one of disequilibrium.
Taxes paid and investment returns are calculated to reflect various investment
situations during one holding period of 20 years and four successive holding periods
of 5 years. Although 5 years may seem implausibly short for a holding period, Gau
and Wang36 found a mean of only 5 years—far less time than their theoretical optimum—for Vancouver apartment properties sold in the period between 1971 and
1985. Data from 2004 tax returns also suggest that holding periods were recently
not much longer than this (see the discussion of table 8, below).37
35 Miller and Geltner, supra note 13.
36 George W. Gau and Ko Wang, “The Tax-Induced Holding Periods of Real Estate Investors:
Theory and Empirical Evidence” (1994) vol. 8, no. 1 Journal of Real Estate Finance and Economics
71-85.
37 Furthermore, data for all residential sales—most presumably to owner-occupiers—sometimes
indicate a surprisingly high number of very short holding periods. In Kitchener-Waterloo,
Steele and Goy found that of 9,776 MLS sales in a 36-month period, 1,123 represented the sale
of a property that sold twice during the period. Thus, under reasonable assumptions, a
minimum of 6.0 percent of properties sold were held three years or less, and the mean length
of holding periods for properties making up the 6 percent would be much less than three years.
The data also included 35 transactions for properties that sold twice in the same quarter or
more than twice in the three-year period. See Marion Steele and Richard Goy, “Short Holds,
the Distributions of First and Second Sales, and Bias in the Repeat Sales Price Index” (1997)
vol. 14, no. 1 The Journal of Real Estate Finance and Economics 133-54. The data period included
months of rapidly rising prices, the peak month of the price cycle, and some months of decline.
It seems reasonable to conclude that a substantial percentage of very short holding periods
were those of investors, especially investors in a position to incur minimal transactions cost.
(2009) vol. 57, n o 3
The evidence reviewed earlier suggests that multi-unit investors are rational in
the sense used here, while the typical small property investor is irrationally exuberant—that is, expects the value of a small property to rise at a faster rate than its rent
(for the assumptions used here, see table 3). This means that the price-to-rent ratio,
which is 12.3 initially, and the cap rate, which is 5.3 percent initially, change dramatically over time. By the end of 5 years, they are respectively 15.3 (only a shade
over the 14.6 ratio for small properties in Australia in 1997)38 and 3.0 percent.
These numbers mean that the investment makes sense only to investors who expect
to sell in the owner-occupier market or to investors who in turn expect to sell in that
market. For this reason, taxes and returns are estimated for the rational case in both
sectors, while, in the irrational case, only condominiums are considered. It is assumed that an investor’s only non-rental income is from employment and that investors are individuals (who may be members of a partnership) residing in Ontario
and who are taxed at the top marginal rate of 46 percent.
The analysis is conducted in nominal dollar terms, consistent with the nonindexation of the tax system. The rate of inflation and price increase for buildings
in the rational set of simulations is assumed to be 2 percent, while the rate for land is
3 percent. The implied real 1 percent annual increase in the price of land is consistent with the fact that a building’s location is fixed. Urban location theory predicts
that when a city is growing, any given location within it becomes more valuable
over time.39 The assumptions for buildings and land together imply that the annual
increase in the value of the property is between 2 and 3 percent, depending on the
proportion of the initial value which is land.40
Results for the Multi-Unit Rental Residential Sector
Table 4 sets out summary data from simulations for the multi-unit investor. Under
the current capital gains treatment, the internal rate of return, after tax, to the investor in a long-term investment is a handsome 18.49 percent (panel a, column 1,
row 1). However, the investment is highly leveraged: this return is based on initial
equity of only 15 percent and such a low equity carries with it a palpable risk. A larger down payment in an investment of this nature would reduce leverage, reduce
risk, and lower the rate of return.
In the next two rows of table 4 are the net present values (npvs) to the government of taxes paid. These are discounted at the government of Canada’s long-term
38 Calculated in Wood and Tu, table 2, supra note 21.
39 Denise DiPasquale and William C. Wheaton, Urban Economics and Real Estate Markets
(Englewood Cliffs, NJ: Prentice Hall, 1996).
40 Physical depreciation of the building is assumed to be offset by capital expenditure every five
years, costing 5 percent of the value of the building. This convenient assumption—which
allows at the same time (1) constancy in real terms of the price expected for new construction,
(2) a positive rate of physical depreciation, and (3) rent changes that are not negative—is taken
from Miller and Geltner, supra note 13.
Table 3 Assumptions Used in the Simulations
1.Multi-unit sector assumptions
n Purchase price is $90,000 per two-bedroom unit (a building of 50 units is valued at
$4.5 million).
n Initial equity is 15%.
n Mortgage loan, 85% of property value, is National Housing Act (NHA)-insured, with
40-year amortization.
n NHA mortgage insurance fee, 5.25% of principal, is added to it (so gross mortgage loan is
90.25% of value).
n Mortgage interest rate is 5.5%.
n Rate of increase in the nominal value of the property is 2.25% per year.
n Rate of increase in the nominal rent is 2.25% per year.
n Initial rent per unit is $1,070 (approximate mean rent for conventional 2-bedroom
apartment).a
n Vacancy rate is 3.2% (rate for conventional Toronto apartments).b
n Operating expenses are 35% of gross effective revenue (gross revenue minus vacancy
allowance).
n Land is 25% of total property value.
2.Small property sector assumptions
n Purchase price is $220,000 for a condominium unit.
n Initial equity is 5%.
n Mortgage loan, 75% of property value, is not NHA-insured and has 25-year amortization.
n Loan against PLC is 20% of property value; payments are for interest only.
n Mortgage interest rate is 5.5%.
n Interest rate on loan is 6.0%.
n Rate of increase in the nominal value of the property is 2.15% per year in a rational market
and 6.6% per year in an irrationally exuberant market.
n Rate of increase in nominal rent is 2.15% per year in both a rational and an irrationally
exuberant market; initial rent is $1,490 (approximate mean rent in fall 2006c for condominium 2-bedroom apartment).
n Vacancy rate is 0.5% (rate for Toronto rental condominiums).d
n Operating expenses are 35% of gross effective revenue.
n Land is 15% ($33,000) of total property value.
a Canada
Mortgage and Housing Corporation, “National Rental Vacancy Rate Inches Down to
2.6 Per Cent,” News Release, December 14, 2006.
bIbid.
c Ibid.
dIbid.
Source: NHA mortgage insurance rates for multi-unit rental are taken from Canada
Mortgage and Housing Corporation, Reference Guide: CMHC Mortgage Loan Insurance for
Multi-Unit Properties (5+ Units) (Ottawa: CMHC, 2009).
bond rate in May 2007—just 4.25 percent. Income taxes paid over the 20-year holding period are a substantial $22,953, much higher than the $12,361 in taxes on capital
gains and recapture of cca paid at the time of sale.
The last four columns of table 4 show the results if the same property were held
over 20 years by four different investors, the frequent-turnover case. The first investor purchases at the same time as the long-term investor, at the end of year 0; the
second investor buys the property from the initial purchaser at the end of year 5.
14,053
16,917
30,971
22,953
12,361
35,314
18.85
31,204
B. With no capital gains tax on rollover:
After-tax internal rate of return to investor (%) . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . 11.13
8,070
3,815
4,921
8,736
9.97
0
11.47
9,148
4,450
5,452
9,901
10.32
5
11.80
10,361
5,174
6,040
11,214
10.64
10
12.10
11,725
5,998
6,693
12,691
10.95
15
Frequent rollover: 5-year holding periods,
year at end of which holding period starts
Note: Numbers may not add or subtract because of rounding.
a NPV refers to the net present value. The NPVs shown in the last four columns are calculated as of the date when the holding period starts; for example,
the NPV to the government of all tax paid for the holding period starting at the end of year 15 is $12,691; this is the NPV, as of the end of year 15, of taxes
in years 16 to 20. The NPV of the four short holding periods shown in column 2 is the NPV, as of the end of year 0, of taxes paid during and at the end of
all four holding periods. The discount rate used to compute the present value of taxes is assumed to be 4.25%, approximately the yield of government of
Canada long-term bonds in April 2007. Details of assumptions used in the simulations are given in the text and table 3. An example of basic spreadsheets
from which these numbers were derived is provided in table 9 in the appendix to this article.
na
28,612
na
18.49
Present value
of values
in columns 3 to 6
20-year
holding period
A. Under current treatment of capital gains:
After-tax internal rate of return to investor (%) . . . . . . . . . NPV a to government of income tax:
Before sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid at sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . Table 4 Investment Returns and Income Taxes Paid, Multi-Unit Rental Apartment Unit
(2009) vol. 57, n o 3
The price paid is that given by the base price, inflated according to the assumptions
in table 3. Rents and operating expenses are the same in years 6 to 10 as they are in
the long-term investment, but the mortgage payments and interest expenses are
higher because the second investor makes a down payment of only 15 percent of the
inflated price. The long-term investor has more equity than the short-term investor
by the end of year 5 because of amortization and the increase in the value of the
property.
The cca taken is higher in the frequent-turnover case, in part because the cca
clock starts anew with each investor. This as well as the higher interest expense and
consequently lower net rental income before cca reduce the taxes paid during the
periods that the investments are held, and these are less than the taxes paid at sales.
The net present value of the amounts for the four successive holding periods is
shown in the second column.41 The present value of the taxes paid annually over 20
years is $14,053, much less than the taxes paid over the same years by the long-term
investor. The present value of the taxes paid at sales by the four short-term investors, $16,917, however, is far greater than the taxes paid by the long-term investor.
The government gains at this stage because of the frequent realization of capital
gains and because CCA is recaptured every five years.42
In conclusion, in the multi-unit case, short holding periods reduce government
revenue. Taxes paid are approximately 10 percent less under four successive holding
periods than under a single long holding period.43
Results for the Rental Condominium Sector in a Rational Market
The results are very different for the condominium investor. The high price-to-rent
ratio—$220,000 to $17,880, or 12.3 percent at the start of the investment—virtually
ensures that this will be the case. As can be seen from table 5, with a long holding
period only $4,312 in taxes is paid during the operating years (panel a, column 1,
row 2). Successive short-term investors pay no taxes whatsoever during their operating years (panel a, columns 3 to 6, row 2), and indeed the first in the sequence receives
a $19 deduction. Much bigger deductions would be possible if the investors already
owned rental real estate, provided that it was profit-making, because the investors
could then deduct the full CCA.
41 This is the present value as of the end of year 0, which puts column 2 on a basis comparable to
column 1. The present values in columns 3 to 6 are as of the end of years 0, 5, 10, and 15
respectively.
42 If the government discount rate were higher than the assumed 4.25 percent, as would have
been appropriately assumed in the past, the difference between the net present value (NPV) of
taxes paid at sale by long- and short-term investors would be even greater.
43 The NPV of the investment to the long-term investor is several times greater than the total
NPV for the four short-term investors: $14,290 as compared with $1,441 (not shown in the
table) if the after-tax discount rate of investors is 9 percent; an offsetting factor is that longterm investors have more equity tied up in the property.
−19
10,920
10,901
4,312
26,118
30,431
6.90
21,041
After-tax internal rate of return to investor (%) . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . −2.66
1,603
−19
3,040
3,021
−2.66
0
−0.17
1,882
0
3,474
3,474
−2.35
5
0.15
2,191
0
3,979
3,979
−2.04
10
0.46
2,535
0
4,545
4,545
−1.74
15
a NPV refers to net present value. The NPVs shown in the last four columns are calculated as of the date when the holding period starts; for example, the
NPV to the government of all tax paid for the holding period starting at the end of year 15 is $4,545; this is the NPV, as of the end of year 15, of taxes in
years 16 to 20. The NPV of the four short holding periods shown in column 2 is the NPV, as of the end of year 0, of taxes paid during and at the end of all
four holding periods. An example of basic spreadsheets from which these numbers were derived is provided in table 10 in the appendix to this article.
na
5,935
na
5.91
Present value
of values
in columns 3 to 6
20-year
holding period
Before sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid at sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . . . . Table 5 Investment Returns and Income Tax Paid, Rental Condominium Apartment in Rational Market
(2009) vol. 57, n o 3
Unlike the situation for the wholesale investor, here the tax payable on sale dwarfs
the taxes paid during the operating years; in the long-term case, at $26,118 (panel a,
column 1, row 4), the tax paid on sale is more than six times the taxes paid over the
holding years. Not only is the tax on capital gains high; the cca recapture is also formidable. This result is the simple consequence of the highly skewed nature of return
to the investor. The big reward for the condominium investor is a large capital gain.
This back-end loading of total return is reflected in a back-end loading of taxes.
The net present value to the investor of after-tax cash flows during the holding
period is negative (not shown in the table). One hears it said that “landlords do not
make any money until they sell.” This is partly the consequence of the high interest
expense arising from the 95 percent financing (the investment is more leveraged than
in the multi-unit case) and partly the consequence of the low rent-to-price ratio.
The most important contrast with the multi-unit case is the much lower tax paid
by a succession of short-term condominium investors than by a single long-term
multi-unit investor:44 the former investors pay under $11,000, less than a third of
the tax paid by the latter investor (compare the last row in panel a of tables 4 and 5,
column 1 of table 4 and column 2 of table 5). This is arguably highly regressive taxation because the condominium rents for about one-third more than the rental
building unit, reflecting its newness. More housing is embodied in the condominium
because it has not suffered as much depreciation, both obsolescence and wear and
tear. The result of the tax system, in interaction with market structure and differing
expectations, is that higher-quality units, which tend to be occupied by higher-income
tenants are burdened less by income tax than lower-quality units. Even when condominium units are held for 20 years, they generate substantially less income tax
than multi-unit apartments held for the same period.45
44 This is the appropriate comparison because the evidence about the length of holding periods
discussed earlier suggests that the typical condominium investor holds only for a short time,
while it seems reasonable to assume that the typical wholesale investor (including REITs) holds
for a longer time. The rate-of-return reasons for the wholesale investor’s longer holding period
become clear when table 4 is examined.
45 The regressive taxation argument depends on the assumption that some of the reduced burden of
income tax is passed on to tenants in the form of lower rent. To the extent that this assumption
is true, the ratio of rents of units owned by condominium investors to rents of units owned by
wholesale investors understates the ratio of the quantities of housing embodied in the units held
by the two kinds of investors. Vince Brescia, of the Federation of Rental-Housing Providers of
Ontario, argues that the really big impact of the increase in condominiums supplied to renters
is the depression of rents for all renters, via the filtering mechanism. (“Filtering” refers to the
change in occupancy of residential units from higher- to lower-income occupants as the units
age). Stagnant real rents, as observed in the last few years in Toronto, certainly imply that the
lesser income taxation of condominium investors has been passed on at least in part to renters.
However, the evidence (see especially C. Tsuriel Somerville and Cynthia Holmes, “Dynamics
of the Affordable Housing Stock: Microdata Analysis of Filtering” (2001) vol. 12, no. 1 Journal
of Housing Research 115-35) suggests that the extent to which filtering delivers greater supply
and lower rents to low-income renters depends on a host of factors. Lower taxes tend to affect
rents most in the submarket where the lower taxes originate.
(2009) vol. 57, n o 3
Short-term investors in condominiums in a rational market earn a negative internal
rate of return (table 5, columns 3 to 6, row 1), given the rent and price assumptions
here. Even long-term condominium investors earn under 6 percent (column 1). Investors would not purchase condominiums if these were their expectations; however,
more optimistic price assumptions yield different results.
Results for the Rental Condominium Sector:
Irrationally Exuberant Market
Returns and Taxes Paid If the Market
Remains Irrationally Exuberant
Results for an irrationally exuberant market—a market in which property prices are
expected to rise at high rate—are shown in table 6. Large increases in prices bring
high capital gains, and the investment is lucrative, which also means high taxes for
the government when investments are held over the long term. However, when
there is a succession of short holding periods, the very high return does not translate
into very high taxes. The present value of all taxes paid by the four short-term investors is only $33,333, less than taxes paid over a long-term investment by multiunit investors (see table 4), because high taxes at sale are offset in large part by high
tax deductions during holding periods. These deductions occur despite the constraints on the use of cca, because high leverage and high purchase prices mean
that interest expense creates large annual rental losses, which are deductible from
other income at full income tax rates, here 46 percent. When a property is sold,
capital gains are taxed at an effective rate of only 23 percent.
Returns and Taxes Paid If the Period of
Irrational Exuberance Is Limited
The above discussion assumes that the expectations of investors are realized. It is
entirely possible that those with good timing can realize their expectations through
two five-year holding periods. The compound nominal rate of increase in the multiple listing service average for the Greater Toronto Area (gta) for the 10-year period
ending in 2007 was 6.0 percent,46 and gta prices have increased less than prices in
the City of Toronto, where most condominiums are located. However, it seems unlikely that prices will rise at this rate for a period as long as 20 years, except perhaps
in gentrifying areas. In the dying years of a price boom, returns to investors will fade,
and taxes are apt to be negative, especially for short-term investors. In this case, the
government in effect is subsidizing this rental stock, not only in terms relative to
the multi-unit sector but also in absolute terms.
46 Calculated from Canada Mortgage and Housing Corporation, “Housing Market Indicators,
Canada, Provinces, and Metropolitan Areas, 1990-2007” data tables (online: http://www.cmhc
-schl.gc.ca/en/corp/about/cahoob/data/data_001.cfm). Analogous rates of increase for other
city regions that are roughly the same as census metropolitan areas are as follows: Halifax
7.0 percent, Montreal 7.7 percent, Calgary 11.1 percent, and Vancouver 7.1 percent.
−26,365
59,697
33,333
4,312
71,177
75,489
16.15
21,041
After-tax internal rate of return to investor (%) . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . 35.39
1,603
−19
13,233
13,214
29.98
0
30.89
−4,138
−4,138
16,373
12,235
24.22
5
27.89
−13,117
−13,117
23,256
10,139
21.00
10
25.80
−26,761
−26,761
33,288
6,527
18.73
15
a NPV
refers to net present value. The NPVs shown in the last four columns are calculated as of the date when the holding period starts; for example, the
NPV to the government of all tax paid for the holding period starting at the end of year 15 is $6,527; this is the NPV, as of the end of year 15, of taxes in
years 16 to 20. The NPV of the four short holding periods shown in column 2 is the NPV, as of the end of year 0, of taxes paid during and at the end of all
four holding periods. An example of basic spreadsheets from which these numbers were derived is provided in table 11 in the appendix to this article.
na
−24,742
na
14.56
Present value
of values
in columns 3 to 6
20-year
holding period
Before sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid at sale ($) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPV to government of all income tax paid ($) . . . . . . . . . . Table 6 Investment Returns and Income Tax Paid, Rental Condominium Apartment in Irrationally Exuberant Market
(2009) vol. 57, n o 3
A Legal Impediment: An Income Gain
Rather Than a Capital Gain?
In the irrationally exuberant condominium housing market, capital gains are such a
dominant component of the total return that any reasonable person would presume
that these gains provide the main investment motivation. If this is true, the gains on
sale should in principle be treated as income and taxed at the income tax rate. If the
Canada Revenue Agency (cra) is able to establish that an expectation of capital gains
motivated an investment, this is the tax rate that will apply. But the cra’s success has
been quite limited, and capital gains actually declared on real property are high. In the
2006 tax year, the mean capital gain on real property reported by individual tax filers
with a gain or loss and with an income of $250,000 or more was $299,667. Net capital
gains in real property reported by all tax filers in the 2005 tax year was $6.8 billion,
more than half the amount reported by those invested in shares.47 These high capital
gains apparently exist along with substantial net rental losses. The mean net rental income for landlords is negative in some groups—for example, interim tax data for 2006
show a loss of $393 for males aged 25 to 29 with rental income.48 MacNevin and Gupta49 have demonstrated the systematic nature of losses such as these in an earlier era.
It is assumed in the remainder of this article that income gain/capital gain issues
can be ignored.
T h e E f f e c t s o f Ta x F o r g i v e n e s s o n R e t u r n
a n d Ta x e s Pa i d : D i f f e r e n t i a l E f f e c t s
o n t h e M u lt i - U n i t a n d Co n d o m i n i u m
Residential Sec tor s
The results discussed earlier show that in a rational market investors in multi-unit
properties are taxed more heavily than those holding condominiums. The difference
is particularly significant when holding periods are short. In an irrationally exuberant market, taxes paid by a succession of short-term condominium investors are also
relatively low. In the likely event of a crash after some years of irrational exuberance,
total taxes paid by a short-term condominium investor are negative. Clearly, the tax
system distorts the rental housing sector.
Tax forgiveness of capital gains tax on rollover exacerbates this situation. Tax forgiveness changes little for the multi-unit investor:50 the rate of return in the long term
47 Calculated from Canada Revenue Agency, Final Statistics—Sample Data, 2007 edition (2005 tax
year), basic table 9 (online: http://www.cra-arc.gc.ca/gncy/stts/gb05/pst/fnl/dwnldf-eng.html).
Capital gains here are net of capital losses.
48 Computed from Canada Revenue Agency, Final Statistics—Sample Data, 2008 edition (2006 tax
year), interim table 4 online (online: http://www.cra-arc.gc.ca/gncy/stts/gb06/pst/ntrm/pdf/
table4-eng.pdf ).
49 Alex MacNevin and Anil Gupta, Tax Motivated Business Loss Realizations: Analysis and Policy
Implications, Tax Analysis Technical Paper no. 2 (Ottawa: Department of Finance, 1986).
50 Of course, this assessment relates to ex ante analysis, which is relevant for assessing a possible
investment; at the end of 20 years, tax forgiveness makes a very large difference to the investor’s
realization.
rises by less than a percentage point (compare table 4, panels a and b, column 1,
row 1). While the effects are greater for four short holding periods (compare table 4,
panels a and b, columns 3 to 6, row 1),51 they are still small relative to those observed in the condominium market during an irrationally exuberant period. In the
latter case, so much of the total return is capital gain that removal of the capital
gains tax markedly increases the short-term investors’ returns (compare table 6,
panels A and B, columns 3 to 6, row 1).
The effect on taxes shows the same pattern. The present value of tax revenue,
substantial to start with, in the multi-unit case declines by only about 12 percent
(table 7, row 3, column 1) in a long-term investment, and less than this in the sequence of short holding periods, when capital gains taxes are forgiven. Taxes fall by
much more for the condominium investment in the rational market (table 7, row 4).
In the irrationally exuberant market, the decline of 72 percent (table 7, row 6) is
huge in the case of the long holding period. In the sequence of short holding periods, taxes fall so much that they turn negative, specifically to −$24,742 (table 6).
The negative taxes—a deduction from taxes paid on non-rental income—that benefit investors during the period in which they hold their investment are not offset
by capital gains tax when they sell their property because this tax is forgiven.
E v i d e n c e o f t h e Imp o r ta n c e o f L o c k- I n
f o r R e n ta l R e s i d e n t i a l I n v e s t m e n t
Lock-in tends to be more important as a deterrent to investment the longer that
residential properties are held. If it is found that despite taxes due on sale, holding
periods are not long, it can be concluded that lock-in is not a factor that greatly impedes residential investment. Evidence of short holding periods in Canada has been
cited above; the best evidence is provided by the econometric study cited earlier,52
which found an average holding period of only five years for apartment properties
in Vancouver.
Recent income tax return data indicate that such short holding periods are not
unusual currently. Dividing the number of tax filers who are rental residential investors (with a positive or negative net rental income) by the number of tax filers who
sell residential property (declaring a capital gain or loss) gives a crude estimate of the
holding period per property.53 The estimate is 7.25 (table 8, column 6, row 3) for
51 Note that these calculations do not take into account the NPV of the taxes that must be paid
on the death of the taxpayer. If the 20-year holding period commences at age 35, then while
capital gains taxes will not be payable at sales, they will be payable when the taxpayer
approaches the age of 80 (which approximates the expected average age at death for people
currently aged 35), or 25 years after the end of the 20-year holding period.
52 Gau and Wang, supra note 36.
53 There are three problems with this estimator. First, capital gains may be realized on second
homes, as well as on rental properties. However, it is reasonable to suppose that the holding
period in these cases is typically very long, especially when the real estate is owned by a couple,
and on the death of one spouse, the real estate passes to the surviving spouse without triggering
realization. Furthermore, the ownership of second homes may affect the numerator as well as
−35.9
−30.9
−76.5
−72.1
Rental condominium apartments in rational market:
Change in NPV of:
Income tax paid at sale (%) . . . . . . . . . . . . . . . . . . . . . . . . . . All income tax paid (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rental condominium apartments in irrationally exuberant market:
Change in NPV of:
−97.3
−174.2
−45.5
−45.6
−13.9
−7.6
−87.7
−87.9
−46.6
−46.9
−13.5
−7.6
0
−100.0
−133.8
−45.8
−45.8
−13.8
−7.6
5
−100.0
−229.4
−44.9
−44.9
−14.1
−7.6
10
−100.0
−510.0
−44.2
−44.2
−14.4
−7.6
15
Note: This table is derived from tables 4 to 6, except for the change in the NPV of income tax paid at sale, which was derived from numbers computed at
the same time as the numbers shown in tables 4 to 6 but not reported there.
−33.2
−11.6
Present value
of values
in columns 3 to 6
20-year
holding period
Multi-unit rental apartments in rational market:
Change in NPV of:
Table 7 Effects of No Capital Gains on Rollover
(2009) vol. 57, n o 3
2005, the most recent taxation year available, not very much greater than the findings
of Gau and Wang. If attention is confined to those with an assessed income of over
$40,000, the estimated holding period is under six years, although this is downward
biased as a result of the inclusion of one-half of capital gains in assessed income.
P o s s i b l e Imp l i c at i o n s o f H i g h ly L e v e r e d
I n v e s t m e n t i n Sma l l R e n ta l P r o p e r t i e s
for Housing and Finance M arkets
There are a number of unfortunate possible implications of highly levered investment in small rental properties. These implications underline the importance of not
inadvertently giving this form of investment tax-favoured status or increasing its
advantage. One implication relates to prices in the housing market. Pavlov and
Wachter54 find, theoretically (and empirically), that the availability of aggressive
mortgage lending instruments magnifies the house price cycle. The booms and busts
of the cycle impose costs on home buyers purchasing primarily for the purpose of
acquiring a dwelling place, result in quite arbitrary wealth redistribution related to
timing differences, and damage the financial system.
A second implication is that overly exuberant investors in small rental properties
directly affect the financial system. Golding et al.55 found that investor properties,
especially in the dying days of the us boom in 2005 and 2006—not long after the
2003 us reduction in capital gains and income recapture tax rates—were much more
likely to involve no or low documentation loans than owner-occupied property. The
authors attribute this in part to the desire to circumvent credit policies. The extent
to which this kind of aggressive lending instrument was embraced by investors in the
United States serves as a general warning about lending of this nature. The impact
the denominator of the estimator because some of these homes are rented out part of the time.
Nonetheless, this problem probably biases the estimator downward. A second problem is that
the estimator implicitly assumes that there is no growth (or decline) over time in the number of
properties held. If there is growth, then the estimator is biased upward. A third problem arises
if the typical tax filer with rental income has two properties and sells only one in any year; in
this case, the mean holding period is closer to 15 years than 7.2 years. More generally, the
estimator implicitly assumes that the number of properties per tax filer declaring net rental
income is the same as the number of properties sold per tax filer declaring a capital gain or loss
in real property. While in the example just given, this leads to a downward bias in the estimator,
the bias can go in the opposite direction. For example, there is an upward bias to the extent that
there are very short-term investors, such as those selling condominiums within a few months of
purchasing them. In this case, a tax filer may report a capital gain representing several properties
sold. Failure to report these flips biases the estimator upward even further; the same is true if
the CRA treats the gain as an income gain, not a capital gain. Therefore, it is not clear on
balance whether the bias is upward or downward.
54 Supra note 4.
55 Edward Golding, Richard K. Green, and Douglas A. McManus, Imperfect Information and the
Housing Finance Crisis (Cambridge, MA: Joint Center for Housing Studies, Harvard University,
2008).
65
100
165
Number (’000)
0.39
1.37
0.69
% of filers
Tax filers having
real property gain or loss
633
563
1,196
Number (’000)
3.82
7.72
5.01
% of filers
9.74
5.63
7.25
Ratio to those
having real property
gain or loss
Investors in rental residential property
Note: An investor in rental residential property is defined as a tax filer reporting net rental income or a net rental loss.
Source: Computed from Canada Revenue Agency, Final Statistics—Sample Data, 2007 edition (2005 tax year), basic tables 2 and 9 (online: http://www.cra
-arc.gc.ca/gncy/stts/gb05/pst/fnl/dwnldf-eng.html, downloaded February 17, 2009).
16,592
7,290
23,882
All tax filers (’000)
Under $40,000 . . . . . . . . . . . . . . . $40,000 and over . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . Assessed income
Table 8 Tax Filers, Investors in Rental Residential Property, and Recipients of Real Property Gains and Losses, 2005
(2009) vol. 57, n o 3
on the financial system when subprime and other aggressive loans went sour in the
United States is too well known to belabour here.
A third implication concerns security of tenure. The possibility of selling to
owner-occupiers, an attractive proposition for investors in small rental properties,
creates a problem for renters: the risk that their tenancy may be terminated. Laws
that protect security of tenure by making it difficult for landlords to evict tenants
who pay their rent in Ontario and many other provinces give purchasers unconstrained eviction rights for owner occupancy. An indication of the importance of
this concern is the plunge of over 6,000 rental condominiums in the gta between
1996 and 2001 as the percentage of owner-occupied escalated.56
Co n c l u s i o n
This article demonstrates that the current income tax system works very differently
for the multi-unit and the small property rental housing sectors in Toronto—and
probably in other cities that generate high capital gains—where investors in the two
sectors are in the top tax bracket. The small property sector is heavily tax-favoured,
especially when holding periods are short and price expectations are irrationally exuberant. To the extent that the high returns shown here are not actually received by
investors in an irrationally exuberant market because they sell too late in the price
cycle, the sector is even more tax-favoured than the simulations show.57 The tax
losses that investors declare during their holding periods are not offset by taxes on
capital gains when they sell. Furthermore, there is research showing that the high
leverage that the tax system rewards, and that is obtainable even by those without a
high net worth from aggressive lenders, may cause widespread damage. It is apt to
magnify the house price cycle; it potentially damages the financial system, as evidenced by the subprime problems in the United States; and it may harm tenants by
impairing their security of tenure.
To the extent that the results emanating from Toronto can be extrapolated to
Canada as a whole, the elimination of capital gains taxes on rollover would only exacer
bate a currently inequitable and potentially damaging situation. It should therefore
be opposed. In addition, the tax advantages of high leverage in real estate investment
should be reduced: there should be investigation into the feasibility and efficiency of
implementing a thin capitalization rule for rental residential property to allow the
deduction of interest expense on debt only up to a maximum ratio, say 85 percent,
of property value.
56 Canada Mortgage and Housing Corporation, Rental Market Report: Greater Toronto Area (Ottawa:
CMHC, 2008) (online: http://www.cmhc-schl.gc.ca/odpub/esub/64459/64459_2008_A01.pdf ),
figure 11.
57 The lower property taxes—not taken into account in this paper—paid by owners of
condominiums and other small rental properties than by owners of multi-unit rental buildings
exacerbate the situation because of much higher rates legislated in the typical Canadian city.
(2009) vol. 57, n o 3
A pp e n d i x
Table 9 Statement of Operations, Unit in a Rental Apartment Building
Held by Wholesale Investor, Individual with Employment
Income Only, Holding Period 5 Years
Year of holding
Price-to-rent ratio . . . . . . . . . . . . . . Potential gross income ($) . . . . . . . . Vacancies ($) . . . . . . . . . . . . . . . . . . . Effective gross income ($) . . . . . . . . Operating expenses ($) . . . . . . . . . . . Net operating income ($) . . . . . . . . . Debt service ($) . . . . . . . . . . . . . . . . . Interest ($) . . . . . . . . . . . . . . . . . . Principal ($) . . . . . . . . . . . . . . . . . Net income after financing ($) . . . . . Capital expenditure ($) . . . . . . . . . . . Before-tax cash flow ($) . . . . . . . . . . Maximum allowable CCA ($) . . . . . . Taxable income ($) . . . . . . . . . . . . . . Income tax ($) . . . . . . . . . . . . . . . . . . Debt coverage ratio . . . . . . . . . . . . . Net after-tax cash flow from operations ($) . . . . . . . . . . . . . . . . . Net after-tax cash flow from sale (year 15) ($) . . . . . . . . . . . . . . . Total after-tax cash flow ($) . . . . . . . NPV a of investment ($) . . . . . . . . . . Internal rate of return (%) . . . . . . . . NPV of taxes before sale to government ($) . . . . . . . . . . . . . . . NPV of taxes at sale to government ($) . . . . . . . . . . . . . . . 0
1
2
3
7.01
12,840
385
12,455
4,359
8,096
4,986
4,403
584
3,693
3,109
1,350
2,343
1,078
1.62
13,129
394
12,735
4,446
8,289
4,986
4,370
616
3,919
3,302
2,646
1,273
585
13,424
403
13,022
4,535
8,486
4,986
4,336
650
4,151
3,500
2,540
1,610
741
(13,500) 2,032
2,717
2,759
2,805
(13,500) 2,032
2,717
2,759
2,805
4
13,726 14,035
412
421
13,315 13,614
4,626 4,719
8,689 8,896
4,986 4,986
4,299 4,261
687
725
4,389 4,634
3,726
3,702
183
2,439 2,416
1,951 2,219
897 1,021
392
9.97
3,815
4,921
Proceeds of sale and tax considerations:
Gross proceeds of sale:
Land ($) . . . . . . . . . . . . . . . . . 26,084
Building ($) . . . . . . . . . . . . . . 74,525
Total sale price ($) . . . . . . . . . 100,609
Overall selling costs ($) . . . . . . . . . . 7,043
Before-tax net proceeds of sale ($) . . 93,566
Capital gain ($) . . . . . . . . . . . . . . . . . 3,566
Taxable capital gain ($) . . . . . . . . . . . 1,783
CCA recapture ($) . . . . . . . . . . . . . . 11,390
Terminal loss ($) . . . . . . . . . . . . . . . . —
Capital gains tax ($) . . . . . . . . . . . . . 820
Income tax on recaptured CCA ($) . . 5,240
Total tax paid on sale ($) . . . . . . . . . . 6,060
After-tax net proceeds of sale ($) . . . 87,507
refers to net present value. The outstanding mortgage loan balance is $77,963.
a NPV
5
(838)
9,543
8,706
Table 10 Statement of Operations, Condominium Apartment Held by
Retail Investor, Individual with Employment Income Only,
Holding Period 5 Years, Classic Rational Assumptions
Year of holding
Potential gross income ($) . . . . . . . . . Vacancies ($) . . . . . . . . . . . . . . . . . . . . Effective gross income ($) . . . . . . . . . Operating expenses ($) . . . . . . . . . . . . Net operating income ($) . . . . . . . . . . Interest on down payment loan ($) . . Debt service ($) . . . . . . . . . . . . . . . . . . Interest ($) . . . . . . . . . . . . . . . . . . Principal ($) . . . . . . . . . . . . . . . . . Net income after financing ($) . . . . . . Capital expenditure ($) . . . . . . . . . . . . Before-tax cash flow ($) . . . . . . . . . . . Maximum allowable CCA ($) . . . . . . . Taxable income ($) . . . . . . . . . . . . . . . Income tax ($) . . . . . . . . . . . . . . . . . . . Debt-coverage ratio . . . . . . . . . . . . . . Net after-tax cash flow from operations ($) . . . . . . . . . . . . . . . . . . Net after-tax cash flow from sale (year 5) ($) . . . . . . . . . . . . . . . . . Total after-tax cash flow ($) . . . . . . . . NPV a of investment ($) . . . . . . . . . . . Internal rate of return (%) . . . . . . . . . NPV of taxes before sale to government ($) . . . . . . . . . . . . . . NPV of taxes at sale to government ($) . . . . . . . . . . . . . . Proceeds of sale and tax considerations:
Land ($) . . . . . . . . . . . . . . . . . . Building ($) . . . . . . . . . . . . . . . Total sale price ($) . . . . . . . . . . Overall selling costs ($) . . . . . . . . . . . Before-tax net proceeds of sale ($) . . . Price of property, end of year 0 ($) . . . Capital gain ($) . . . . . . . . . . . . . . . . . . Taxable capital gain ($) . . . . . . . . . . . . CCA recapture ($) . . . . . . . . . . . . . . . Terminal loss ($) . . . . . . . . . . . . . . . . . Capital gains tax ($) . . . . . . . . . . . . . . Income tax on recaptured CCA ($) . . . Total tax paid on sale ($) . . . . . . . . . . . After-tax net proceeds of sale ($) . . . . 0
1
2
3
17,880
89
17,791
6,227
11,564
2,714
12,086
8,894
3,192
(44)
(3,236)
—
(44)
(20)
0.78
18,264
91
18,173
6,351
11,822
2,714
12,086
8,716
3,370
392
(2,978)
392
—
—
18,657
93
18,564
6,478
12,086
2,714
12,086
8,528
3,558
844
(2,714)
844
—
—
19,058 19,468
95
97
18,963 19,371
6,608 6,740
12,355 12,631
2,714 2,714
12,086 12,086
8,330 8,120
3,756 3,965
1,312 1,797
10,323
(2,444)(12,492)
1,312 1,797
—
—
—
—
(11,000) (3,215)
(2,978)
(2,714)
(2,444)(12,492)
(11,000) (3,215)
(2,978)
(2,714)
32,686
(2,444) 20,194
4
(6,568)
−0.03
(19)
3,040
38,256
206,463
244,719
17,130
227,589
220,000
7,589
3,794
4,344
—
1,745
1,998
3,744
223,845
aNPV refers to net present value. The outstanding mortgage loan balance is $191,159.
5
(2009) vol. 57, n o 3
Table 11 Statement of Operations, Condominium Apartment Held by
Retail Investor, Individual with Employment Income Only,
Holding Period 5 Years, Irrational Assumptions
Year of holding
0
1
Potential gross income ($) . . . . . . . . 17,880
Vacancies ($) . . . . . . . . . . . . . . . . . . . 89
Effective gross income ($) . . . . . . . . 17,791
Operating expenses ($) . . . . . . . . . . . 6,227
Net operating income ($) . . . . . . . . . 11,564
Interest on down payment loan ($) . 2,714
Debt service ($) . . . . . . . . . . . . . . . . . 12,086
Interest ($) . . . . . . . . . . . . . . . . . . 8,894
Principal ($) . . . . . . . . . . . . . . . . . 3,192
Net income after financing ($) . . . . . (44)
Capital expenditure ($) . . . . . . . . . . . Before-tax cash flow ($) . . . . . . . . . . (3,236)
Maximum allowable CCA ($) . . . . . . —
Taxable income ($) . . . . . . . . . . . . . . (44)
Income tax ($) . . . . . . . . . . . . . . . . . . (20)
Debt coverage ratio . . . . . . . . . . . . . 0.78
Net after-tax cash flow from operations ($) . . . . . . . . . . . . . . . . . (11,000) (3,215)
Net after-tax cash flow from sale ($) . . . . . . . . . . . . . . . . . . . . . . Total after-tax cash flow ($) . . . . . . . (11,000) (3,215)
NPV a of investment ($) . . . . . . . . . . Internal rate of return (%) . . . . . . . . NPV of taxes before sale to government ($) . . . . . . . . . . . . . . . NPV of taxes at sale to government ($) . . . . . . . . . . . . . . . 2
3
18,264
91
18,173
6,351
11,822
2,714
12,086
8,716
3,370
392
(2,978)
392
—
—
18,657
93
18,564
6,478
12,086
2,714
12,086
8,528
3,558
844
(2,714)
844
—
—
4
19,058 19,468
95
97
18,963 19,371
6,608 6,740
12,355 12,631
2,714 2,714
12,086 12,086
8,330 8,120
3,756 3,965
1,312 1,797
10,323
(2,444) (12,492)
1,312 1,797
—
—
—
—
(2,978) (2,714) (2,444) (12,492)
74,704
(2,978) (2,714) (2,444) 62,212
18,486
28.98
(19)
13,233
Proceeds of sale and tax considerations:
Land ($) . . . . . . . . . . . . . . . . . 53,147
Building ($) . . . . . . . . . . . . . . 250,248
Total sale price ($) . . . . . . . . . 303,395
Overall selling costs ($) . . . . . . . . . . 21,238
Before-tax net proceeds of sale ($) . . 282,157
Capital gain ($) . . . . . . . . . . . . . . . . . 62,157
Taxable capital gain ($) . . . . . . . . . . . 31,079
CCA recapture ($) . . . . . . . . . . . . . . 4,344
Terminal loss ($) . . . . . . . . . . . . . . . . —
Capital gains tax ($) . . . . . . . . . . . . . 14,296
Income tax on recaptured CCA ($) . . 1,998
Total tax paid on sale ($) . . . . . . . . . . 16,294
After-tax net proceeds of sale ($) . . . 265,863
refers to net present value. The outstanding mortgage loan balance is $191,159.
a NPV
5

Canadian Tax Journal, Vol. 57, No. 3, 2009

Transcription

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