How to make mortgage interest deductibility equitable between generations?

Why DO we treat home "investors" differently than "owners?"

Some blog posts are more gripping than others. I get that.

The feedback on yesterday’s (see “Would mortgage interest deductibility help solve Canada's housing affordability crisis?” Nov 22-23) has been both thoughtful and wide-ranging. Although I didn’t have time ask Kevin Page, our former Parliamentary Budget Officer, about the seismic budget hit the idea might represent during our session yesterday with Amber Kanwar on BNN Bloomberg, there are some obvious hurdles to tackle before getting to that stage of the thought process.

Several of you thought that if a home buyer was going to be permitted to deduct their interest payments, any future price appreciation should be subject to capital gains. This is exactly how the current tax regime handles anyone that buys a condo for investment purposes: the interest on the “investment loan” they take out is deductible, but since the condo is a “business,” the annual net income and future capital gains are both subject to tax. If we let “investors” deduct their mortgage interest on spec properties, which hits the federal treasury, it seems unfair to deny a similar benefit to a young couple or family just because they occupy the address in question.

If you think about it, the tax system is designed to get us what we want/need as a collective, whether it be revenue to pay for stuff we can’t do without (schools, National Defence and hospitals), certain types of corporate investments, targeted summer job placements, tax relief for parents with physically-challenged children, increased retirement savings and so forth. The thousands of assembled rules and programs are all intended to either encourage — or discourage — certain societal and corporate behaviours. (Or, in the case of the Liberal’s newish luxury tax on boats, cars and airplanes, to just “stick it” to a certain type of voter, merely because they can.)

If, for argument’s sake, we allowed new homebuyers to deduct their interest expenses, we shouldn’t be glib about being fair to those who didn’t have that benefit when they acquired their first home, say, just last year. If a new buyer elected to deduct their interest at the time they acquired that mortgage and first home, Canada Revenue Agency could easily require that they:

• arrange a mortgage via either a bank, credit union, Trust Co. or other regulated mortgage provider; this avoids a parental, artificial or non-arms length mortgage at an interest rate that’s well above market

• agree to be subject to capital gains taxes upon the sale of the home; in the case of a marriage or common-law situation, consent would be either required or assumed for all parties that ultimately benefit from the proceeds of that home

• agree to eventually sell their home via the MLS service; the theory being that by broadcasting the property’s availability for sale, we should avoid a scenario where a below-market private transaction is done to a family member at some point down the road in an effort to reduce whatever tax might be payable at that time

• in the case of death, a deemed disposition would take place and the estate would pay the implied capital gains tax in the event the home was left to a family member

These are just a few of the obvious considerations, and as easy as it is to apply the cap gains tax rules in this scenario, there’s another wrinkle.

How would we treat the right that Canadians have to a $971,000 (Ed. note: updated $ value courtesy of a reader) Lifetime Capital Gains Exemption? Shouldn’t that also be available to a homeowner, even if this corner of the Tax Code is more the traditional domain of a farmer, stock trader or small business owner? I don’t have a quick answer to a tough question, recognizing that most Canadians never have the good fortune to utilize their “free” $971k exemption. It seems weird that a condo investor can flip a couple of condos tax-free, but a new couple would pay capital gains tax on every dollar of profit they earned on the sale of their home in the event they availed themselves of a mortgage interest deduction program.

What if you traded-up homes as your family grew, and rolled your equity and mortgage into the new place, as most of us do when we move from house #1 to house #2? Would you have to pay capital gains tax at that time? If so, wouldn’t that be a disincentive to ever moving, as is currently on view in the USA with their 30-year mortgages? As you can see, the Finance Dept. memo on this challenges and complications of getting this policy idea right could be as thick as a telephone book.

I took yesterday’s model and added in a new column reflecting the tax that would be recovered by the Crown in seven years in the event the home was sold for $300k more than was paid. $300k might sound like a lot, but it’s a reasonable annual gain of ~4.3%:

You’ll note that the home buyer(s) permanently gave up $85,045 of joint lifetime TFSA room as a result, which is the gross difference between the after-tax interest they deducted ($140,545) and the capital gains tax paid ($55,500) on the sale. Is that the right way to think about it? Whether the dollars are net or gross, should you be able to contribute to a TFSA in the same year that you needed (given the expensive housing market) to deduct your mortgage interest? I wouldn’t have thought you could afford a TFSA contribution, in any event. More importantly, it seems like a balanced approach as we try to be fair to your neighbour, who didn’t have this program when they bought their first home last year.

Assuming no capital gains exemption is permitted on owner-occupied single family homes, the tax due in seven years is a modest $55,500 (25% of $300k gain after the 6% real estate commish; things like closing costs and real estate fees should also be deductible). Considering you earned a $300k gross profit on your original $200k down payment, that’s a fabulous IRR over seven short years. You now have your original down payment of $200k, plus $167k of after-tax gains, as well as ~$110k of additional equity via your mortgage amortization payments with which to buy that new home. At that point, something in the $1.5-$1.75M range might be within your grasp, subject to your new income level and how many mouths you have to feed.

That’s a long, long way from the $680k home you were eligible to look at just seven years earlier in Scenario One — but a clear example of how the next generation can build some wealth (the numbers are directionally similar for the $500k home in Chilliwack, BC). In the event that the combination of government and private forces that are trying to get more housing stock built over the next five to ten years succeed in their monumental task, there will be plenty more homes to choose from. At that point, you might be able to swing upgrading to a larger home without needing the TDSR relief that comes via interest deductibility — meaning this temporary program could expire as planned, which would come as a great relief to my friends at Finance.

Could this work, without breaking the federal budget? To think.

MRM

(this post, like all blogs, is an Opinion Piece)

(photo: Milkman (A), New York, 1951, by Irving Penn - © Conde Naste)