Capital Gains Taxation as a Housing Policy Tool in Canada

Publish by postcovidcities.com, April 2024, and linked here canonically to redirect search engines there.

Summary: Canada’s 2024 federal budget will raise the capital gains inclusion rate from 50% to 66.6% for corporations and for individuals’ gains exceeding $250,000, spurring debates over potential impacts on housing sales, especially for second properties. Analysts suggest this policy could curb housing speculation by increasing tax burdens on investment property sales, potentially easing housing affordability issues. However, implementing a gradual or targeted approach, such as higher inclusion rates for real estate only, may more effectively discourage speculative purchases and stabilize housing markets over time.

 

Capital Gains Taxation as a Housing Policy Tool in Canada
Dr. Alan Walks, University of Toronto

In the budget released on April 16, the federal Government of Canada (2024) proclaimed its intention to change, effective June 25, the capital gains inclusion rate from 50 percent to 66.6 percent, for all corporations and businesses, and for individuals’ capital gains above $250,000. (The first $250,000 of capital gains among individuals will still incur the 50 percent inclusion rate). This has led to some debate among scholars, and in the newsmedia, with expectations it could lead to a glut of listings in the private housing market (e.g. Feinstein 2024). Home owners, it is claimed, could be incentivized to sell their properties before the June 25 cutoff, in order to minimize their tax paid on the profits of the sale. Given this debate, it is worth exploring the potential role of such a capital gain tax as a tool of housing policy.

A capital gains tax was first implemented by the federal government in 1972 on the recommendation of the Royal Commission on Taxation, with an inclusion rate of 50 percent. This was temporarily raised to 66.6 percent in 1988, and furthermore to 75 percent in 1991, then lowered back to 50 percent in the year 2000 (see Senate of Canada, 2000). Note that the inclusion rate for capital gains is not the same thing as the rate of taxation. An inclusion rate of 50 percent means that half of the total capital gain realized from the selling of an asset will be included as income for the purposes of calculating taxation owed. That is, one half of the profits are tax-free, and the other half are then taxed at one’s marginal rate. In 2023, the OECD reports that the average rate of taxation for individuals in Canada was 25.6 percent. Of course, actual taxation rates differ widely among the population, and among different types and sizes of business, as well as varying among the provinces and territories, so the following is merely suggestive. At this level of taxation, a capital gains inclusion rate of 50 percent would result in an effective tax rate of roughly 12.8 percent on total realized capital gains, on average (50 percent of 25.6). If the inclusion rate rises to 66.6 percent, then two thirds of capital gains are included in the calculation, resulting in an effective tax rate of 16.9 percent of the total realized capital gain, on average (66.6 percent of 25.6). This higher inclusion rate would apply to all capital gains realized by corporations and other business, whereas for individuals the federal intention is for the inclusion rate to remain at 50 percent for the first $250,000, with the higher (66.6 percent) inclusion rate only applying to the amount of realized gains above this threshold.

It should also be noted that one’s marginal tax rate will be higher when a large sum is included as income for tax purposes. For instance, the marginal taxation rate for incomes above $246,752 – the highest individual income tax bracket in Canada – in 2024 is 33 percent. Although actual tax rates will differ based on individual situations, for the purposes of explanation we can use this as a benchmark for calculating expected differences in capital gains taxes in the case of sales of expensive assets like houses.

Implications for Sales of Second Properties

Among other things, this change in the capital gains inclusion rate will have implications for how much tax is paid on the sale of residential housing for those selling second properties. In Canada, one’s primary residence is exempt from any capital gains tax, so when it comes to housing, only second properties (mainly investment properties and recreational properties) are affected.

An exercise using simple averages shows how this might affect sellers of second properties. According to the Canadian Real Estate Association (CREA, 2024), the average price of house across Canada in March 2024 was $698,530. If one were to have bought the same (average priced) house twenty years earlier in 2004, it would have cost $245,149, as reported by CREA (CBC, 2005). Selling this house in 2024 would produce a realized capital gain upon sale of $453,381. Under the old rules, only 50 percent of this $453,381 capital gain would be included in the tax calculation (that is, $226,690.50 would be included). If the latter were taxed at the highest marginal rate of 33 percent (putting the taxfiler into the top marginal rate), this would lead to taxes of $74,807.87 paid solely on the sale of the house. Under the new rules for individuals announced in the 2024 federal budget, the first $250,000 of capital gain has an inclusion rate of 50 percent (that is, $125,000 is included), whereas 66.6 percent of the remaining capital gain ($203,381) is included, in the tax calculation. The latter leads to a total of $259,231.46 being included as income, and when taxed at the marginal rate of 33 percent leads to a federal tax paid on the capital gain of $85,546.38. This suggests that, under the new proposed rules contained in the 2024 budget, individuals selling second properties priced at close to the Canadian average can expect to pay roughly 14.4 percent more federal tax on capital gains (in this case, the difference between $74,807.87 and $85,546.38), compared to the older flat inclusion rate of 50 percent.

Capital Gains Taxation as Public Policy

There are a few different reasons why governments might want to use aspects of the capital gains tax, such as the inclusion rate, as a policy tool.

First, because capital gains are more concentrated among the wealthy, adjusting the inclusion rate has implications for the social distribution of tax rates (and thus after-tax income), and in turn, for the articulation of economic inequality. This is in fact how the federal government has justified raising the inclusion rate. They note that because taxes on capital gains are lower than for labour income, “[d]ifferences in taxation rates between income earned from wages, capital gains, and dividends currently favour the wealthiest among us”… and “The government is committed to a fair and progressive tax system. By increasing the capital gains inclusion rate, we will tackle one of the most regressive elements in Canada’s tax system. Our government is proud to be reducing this inequity” (Government of Canada, Federal Budget 2024, pages 334 and 335). In this case, raising the capital gains inclusion rate fulfils a policy promise to reduce after-tax income inequality, although in a small incremental way.

Capital Gains Taxation as Housing Policy

Second, capital gains taxes, as a tax on profit from asset sales, can also be used as a tool of housing policy. Affordability – both of rental housing but also owner-occupied housing –  has diminished severely over the last decade, particularly during the COVID-19 pandemic (Crombie and Golden 2022). While scholars and other analysts have pointed to a number of potential causes of this declining affordability (see Hawes and Grisdale, 2021; Pasalis 2022), a key one has been the incentive for speculators to purchase housing – often second properties – on the expectations of capital gains. The added demand from price-insensitive speculators bids up prices, and speculators/investors have been among the fastest-rising category of purchasers of housing during the pandemic (see Punwasi 2021, 2022; Withers 2024). One irony is that federal policies that incentivize banks to provide larger and more plentiful mortgages (due to the federal government insuring and buying mortgages and mortgage-backed securities from the banks), and other federal interventions to reduce mortgage interest rates, have been a strong factor incentivizing speculation in housing and driving up demand, prices, and debt levels (Kalman-Lamb 2017; Macbeth 2015; Walks 2013, 2014, 2021; Walks and Clifford 2015). Raising the capital gains inclusion rate will reduce incentives for speculation in housing markets. It remains to be seen how powerful a disincentive the change from a 50 percent to 66.6 inclusion rate will ultimately be, as profit levels in housing markets also depend on interest rate levels, rent levels, and rates of house-price inflation. If raising the capital gains inclusion rate is able to reduce speculation enough that house prices increase at slower rates than other assets (like stocks/equities), this could ultimately lead to more stable (or even potentially slowly declining) housing prices. The latter would create a more affordable housing market, and thus could be of wide public benefit. The higher the capital gains inclusion rate, the larger the impact in reducing real estate speculation.

If reducing speculation in housing and real estate is a key policy objective, it is also possible to tailor changes to the capital gains inclusion rate so that higher inclusion rates only apply to real estate transactions, with lower inclusion rates for other types of asset classes and investments. There has been criticism of these federal changes to the capital gains inclusion rate from business owners and chambers of business, on the grounds that it could reduce business investment in Canada at a time of declining productivity (Hill and Fuss, 2024). However, there is no reason why the inclusion rate must be the same for all types of asset classes. It could, for instance, be higher for sales of residential property, and lower for other types of transactions. Indeed, if the federal government were interested in targeting speculation in housing, it would be more effective to raise the inclusion rate for sales of second properties above 66.6 percent. At this inclusion rate of two thirds, the tax paid on profits from real estate speculation is still significantly lower than the tax paid on earned income. Why should labour income be taxed at a higher rate than profits from ‘house flipping’? The latter is clearly in the category of ‘unearned’ income. If the federal government were serious about using the capital gains inclusion rate as a policy tool for strongly reducing speculation, they could, for instance, raise the inclusion rate on sales of second properties to 100 percent, placing it at the same rate as labour income.

Alternatively, they could set a flat level of tax on capital gains from sales of second properties. There is precedent for this approach, at the level of Ontario provincial policy. In April of 1974 the Ontario government – led by the Progressive Conservative Party of Ontario – enacted an anti-speculation tax of 50% of the realized gain from real estate sales. It did this to address rapidly-rising real estate prices fueled by speculation, just like today (Aaron, 2022). And it worked. Speculators began trying to get out of deals that had yet to close. They tried to sell their speculative purchases, knowing that this new tax would reduce demand from other speculators, and eventually reverse recent price gains. If they held on too long before selling they would be left holding losses. The result was that there was an immediate supply of existing housing put back onto the market, and this one policy, according to Aaron, was harmful as it “caused what was probably the worst market crash since the Great Depression of 1929”. While prices reversed, the crash did not last long, but instead stabilized at a lower price point – one set by those who were purchasing housing for its use value, not as a speculative investment. This policy is said to have “chilled the housing market for 11 years” (Turner 2021), which meant housing remained affordable over this time. If a stable, affordable, housing market relatively free of speculation is a desired policy objective, this policy would then seem useful.

Using the Timing of Implementation to Boost Market Supply

This story also raises the issue of tailoring the timing of implementation of tax changes, and using control over timing as a policy tool. As the Ontario story from 1974 demonstrates, setting a change that will have continued impacts in the future can incentivize sales in the present. One of the claims that governments at each level have been making about housing is that there is a lack of sufficient supply. While many of the arguments regarding housing supply of new housing are suspect (see Punwasi, 2023; School of Cities 2024; Todd 2021), it is also true that there is a lack of affordable housing. If speculators could be incentivized to sell speculative investments, as occurred in Ontario in 1974, this could significantly boost existing market supply in the short run and perhaps go some way to tempering prices of existing housing.

Currently, the federal government has indicated they intend for the higher inclusion rate to come into effect on June 25, 2024. Some have claimed that this is incentivizing owners to sell by this date, or face the higher inclusion rate afterward (see Feinstein 2024). However, real estate transactions typically close after 60, or 90, days. Only those transactions that firm up by early May really have much of a chance of closing by June 25. After that date, some may seek to hold on to speculative investments in the hope that the government will walk back the tax changes at a later date. At very least, there may be little incentive to sell this year, once June 25 has passed, if there has been no rush to sell before then. That is, the current timing schedule does not produce a sufficiently long enough window to incentivize much selling in the short term, and it may even reduce the incentive to sell after June 25, and thus not have much of an effect on market supply nor housing affordability afterwards.

If the government wanted to use these changes to the capital gains tax to boost supply, they could increase the inclusion rate in steps. As an example, they could raise the inclusion rate on sales of second properties to 60 percent in June, then 70 percent in September, then 80 percent in December, 90 percent the following March, etc (this is just one potential way of structuring the change). Not only would this incentivize a consistent flow of listings into the market, it would signal that the likelihood that price gains in the future will be significantly reduced with each passing month, reducing the incentive to wait for potential gains and increasing the urgency to sell. Again, these changes in the inclusion rate could be narrowly applied to sales of second properties – perhaps even second properties only found in larger metropolitan areas, or metropolitan areas with real estate values seen as too high. This would not only reduce the effect on investments in other realms of business, but would incentivize investment to flow into more productive forms of business, and away from real estate speculation in existing housing. This could be a public benefit of such a tailored approach to the capital gains inclusion rate regime.

Conclusion

This commentary has discussed how changes to the federal capital gains taxation inclusion rate could be used as a tool for meeting public policy objectives, especially those related to housing. There is the potential for using this otherwise obscure tax mechanism for reducing real estate speculation, boosting the supply of housing, and producing more affordable housing markets. Currently, the new rules announced in the 2024 federal budget do not appear to have been designed with housing policy objectives in mind, as the June 25 cutoff is too soon to incentivize much selling by speculators, and could even reduce market supply in its aftermath as speculators hold on to speculative investments. Furthermore, the new inclusion rate will apply equally to all forms of capital gains, but this does not have to be the case. The capital gains inclusion rate could differ by asset class, with sales of second properties receiving a higher capital gains inclusion rate than investments more productive aspects of the economy. This would not only disincentivize real estate speculation, but it would comparatively incentivize productive investment. Finally, the capital gains tax inclusion rate could be selectively applied to sales of second properties in higher-priced metropolitan areas, and be implemented in a series of steps in which the inclusion rate rises over time. This would incentivize sales of any second properties for which the investors were banking on future capital gains, and help boost the supply of existing housing in places where it is most needed, at a time when developers of new housing have reduced to cancelled projects.

References

Aaron, Bob (2022) Home speculation tax would harm, not help. Toronto Star. February 19, 2022. H6.

CBC (2005) Resale home prices rise more than 10 per cent in 2004. Toronto: CBC, January 17, 2005. Accessed online at: https://www.cbc.ca/news/business/resale-home-prices-rise-more-than-10-per-cent-in-2004-1.550399

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Feinstein, Carrie (2024) Time to sell your investment property? Claim your cottage as a principal residence? How to navigate the capital gains tax changes. Toronto Star. April 28, 2024. online: https://www.thestar.com/real-estate/time-to-sell-your-investment-property-claim-your-cottage-as-a-principal-residence-how-to/article_b54d3cdc-0250-11ef-a003-e734fd5976e6.html

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Header photo by Dillon Kydd on Unsplash.