In October 2016, the federal Minister of Finance, the Honourable William Morneau, announced two major changes to the Canadian housing market regulation. The first change affects which properties are eligible for the Principal Residence Exemption and the second change regards the mortgage stress test that has been imposed upon insured mortgages. Each of these changes is examined below.
The Principal Residence Exemption
A “Principal Residence” is a term in tax law that refers, in simplistic terms, to the primary home that the taxpayer or a member of the taxpayer’s immediate family owns. The home does not have to be the property where the taxpayer spends the most time, but it does have to be lived in by an owner or a member of the immediate family for some time during the tax year. As a result, taxpayers may designate their cottages or second homes as their Principal Residence.
The Principal Residence Exemption (the “PRE”) exempts the capital gains obtained at the time that the property is disposed of from capital gains tax. As such, taxpayers typically designate whichever property has had the largest capital gains as their Principal Residence. For instance, if the capital gains on the primary home is $100,000, but the capital gains on the cottage is $500,000, then it makes more sense to claim the PRE on the cottage. While this sounds simplistic, in reality the test to determine whether, and how much of, the capital gains are exempt is a complicated equation
An example of how this exemption works may clarify why the equation behind it is complicated. Imagine that a taxpayer buys two properties in the year 2000. She uses one property as her main home, and the other as a cottage. In 2010, she sells the home and there is a capital gain of $100,000. She claims the PRE and thus does not have to pay any taxes on the capital gain. In 2015, she sells her cottage, and the capital gain on her cottage is $500,000. When she tries to claim the PRE, however, she finds that she is unable to claim it for the years of 2000-2010, because she already declared a Principal Residence for those years. Thus, the taxpayer will be only be able to claim her cottage as her Principal Residence from 2011-2015 and she will have to pay capital gains on the remaining period.
The new changes to the PRE are intended to close a loophole that allows foreign buyers to purchase homes in Canada for investment purposes, and then use the PRE to avoid paying capital gains tax on those properties when they are sold.
The new changes to the PRE are two-fold. First, all taxpayers must claim the sale of their Principal Residence on their tax return, even if there is no tax owing on the Principal Residence. This change takes effect with the tax filing due in the spring of 2017 and impacts anyone who sold their primary residence in 2016.
The second change is directed more specifically at the foreign buyers. Now, taxpayers must be residents of Canada in the year that they purchased the property in order to be eligible for the full exemption. The Canadian Government believes that this will have the desired effect because of the complicated equation behind determining the PRE amount.
Together, these Principal Residence rules may potentially have a large impact on taxpayers because they will now have to claim the exemption at the time of the sale of the property, whereas before they did not need to claim it at all. While this will not affect most Canadians’ eligibility to claim the PRE, it may affect their ability to successfully receive the exemption if they don not properly claim it on their taxes.
The Mortgage Stress Test Changes
The second change recently made by the Canadian government to address the overheated housing market is the implementation of a mortgage stress test. Currently, interest rates are at a very low mark, making them advantageous for purchasers. As a result, purchasers may be more inclined to take on larger mortgages than they would otherwise be capable of buying. However, interest rates may change over the life of a mortgage, and purchasers may find that as interest payments go up, they are no longer be able to afford the mortgage.
The new mortgages changes are meant to minimize this risk. These changes require all insured mortgages to pass a “mortgage stress test,” which means that the individuals taking on the mortgage must not only receive approval at the current interest rates, but must also receive approval at the five year standard rate of 4.64%.
However, these rules will have the effect of making it more difficult for first-time buyers to purchase their first property. The rules only affect insured mortgages, and almost all insured mortgages are mortgages where less than a 20% down-payment is placed on the property. Since few first time buyers have sufficient equity to place 20% down on the property, this mortgage stress test will likely hurt them more than purchasers who have previously owned a home. As a result, many aspiring home owners may find that their dream home, or any home at all, is out of their economic reach.
Rebate for First-Time Home Buyers
A recent announcement by the Ontario provincial government brought good news to first time home buyers. Effective January 1, 2017, the land transfer tax rebate for first time home buyers is doubling from $2,000 to $4,000.
Overall, these federal changes to the Canadian housing market are an attempt to make home ownership more accessible to greater number of Canadians. While these changes may, in the long term, close a loophole used by foreign buyers and prevent purchasers from taking on mortgages they cannot afford, in the short term it may cause difficulty for taxpayers trying to claim the Principal Residence Exemption and may shut potential purchasers out of the housing market altogether. As a result, the full effect of these rules may not be known for years to come.