June 20, 2003
The federal government’s last budget made a serious commitment to housing – a further $320-million in 2003 added to the $680-million in funding allocated in 2001 for subsidized housing. This is a billion dollars – big money in any league – to be matched by provincial contributions. But it will build only about 20,000 new rental units of the 150,000 needed to accommodate Canada’s economic growth, and even that will only happen over five years, and only for “poor” tenants.
What of the 90% of tenants who live in ordinary rental housing provided by the private sector, tenants too “rich” to qualify for subsidized housing and too poor to buy?
In large cities in particular, many tenants are trapped in rentals that are deteriorating prematurely and they frequently pay more than they should because of the discriminatory tax burden the federal government imposes on rental investors – taxes borne ultimately by tenants.
Most of the ills in the private rental housing market stem from one cause: Private investors cannot build new “market” rental housing because federal tax changes made in the early ’70s actively discriminate against rental housing investments, especially by small investors who provide most of Canada’s rental housing.
The most significant change in 1971 – other than the accelerated depreciation then allowed – was to no longer allow for the “rollover” of a rental investment upon sale.
Before 1972, there was no capital gains tax and building owners could postpone paying taxes due upon the sale of a residential property if they reinvested in a like property within a year. “Rollover” continues to apply to most other businesses, and to motels, hotels and family farms. It is the tax law for rental housing in the United States and most other countries.
“Rollover” simply reflects how rental investments grow, not by adding another floor but by selling something small and using the equity to build something larger. The liquidity provided by rollover is essential to an operating rental marketplace because every investor has to consider an exit strategy. The huge penalty of the capital gains tax – as high as 75% over the past 30 years – and the tax on capital cost allowance recapture, has made selling a rental building – as long as the investor was going to remain in the rental business – a bad investment.
Then there is the fundamental unfairness of applying the capital gains tax against properties held for many years, because much of the notional increase in value simply reflects inflation. Considering that we’ve had a 377% increase in inflation since 1972, few rental buildings have increased that much, outside of a few “hot markets.” Most building owners have lost capital after they pay the tax upon sale.
Compare the tax consequences of holding an apartment building for 20 years versus a common stock for a year. For the latter, the increase in value is likely due to something beyond inflation. The sale is made, the capital gains tax is paid, and the investor then searches for another undervalued or promising stock to invest in.
For the long-term investment in a rental, the sale triggers the tax, but where is the lower-priced rental in which to reinvest? It does not exist because all the properties tend to have about the same increase in value. Because Canada’s capital gains tax is not indexed for inflation, long-term investments are discouraged.
“Rollover” helped keep rental housing well maintained because vendor tended to do repairs before sale, and new owners would improve the property to improve rentability. With few sales now taking place, that reason for renovation and maintenance is lost, as seen in the state of many rental buildings.
Although a rental business should fit the criteria for being a “small” or “active” business, federal tax law treats residential rentals as though they were large businesses – with twice the income tax rate, and as though they were stocks or bonds, rather than operating businesses. Rental businesses are even discriminated against with respect to the GST.
Ultimately, the tenant and not the owner/investor, pays. A 1999 study of these extra federal taxes on rents compared a stream of income from a motel – which can take advantage of rollover, small business tax treatment, and so on – and apartments. It found that on an average Victoria, B.C.-area one-bedroom apartment renting for $608 per month, the extra tax – not the tax, but the extra tax – was $113 per month. Added to those tenant costs are higher rents because of tight markets and lower maintenance.
Study after study done by everybody except Ottawa demonstrates that federal tax laws specifically pick out rental housing from other similar investments for adverse tax treatment.
The tax rules discouragement of maintenance of older buildings also leads the tenant to ask, “Why should I look after my suite, if the landlord does not care about the building?”
More threatening, over the long term, both to tenant housing choice and to the shape of our cities, is the incentive caused by punishing taxation for investors to just get out of the rental business entirely when an alternative land use – commercial or condo development – presents itself. In a new condominium versus a comparable rental, an owner would pay at least $200 per month less than the tenant, or about $2,400 per year. At the end of 25 years, the tenant has paid shelter costs of $60,000 more than the owner, who by then has paid off the mortgage, lives rent free and has a very large tax-free capital gain upon sale.
That few are investing in the building of new “market” rental housing, despite historically low interest rates, is not news. But given current trends, within a very few years many tenants will be unable to find rental housing at all, and will be moving home with mom or doubling up.
One of a series; Tex Enemark is a Vancouver-based public policy consultant and a former B.C. deputy minister with an interest in housing issues.