Capital gains tax break becomes part of a double whammy when home prices fall: Don Pittis

When property prices are rising, even just a little,there is almost no better place to keep your money than invested in your own home.

Monthly real estate numbers released Friday show the price of the average Canadian home rose again in September, up almost 10 per cent in the past year.But if and when that trend reversesand pricesturnflat or startto fall, the investmentadvantages of owning a home can take a dramatic turn for the worse. The reason is tax.

At various times in the past, differentgovernments have decided that having citizens own their own homes was a good thing, worth encouraging with tax breaks.

Sweetening the pot

In the U.S., the government decided the way to encourage and rewardhome ownership was to sweeten the pot byallowing buyers to deduct their interest costs from their taxable income.

That effectively means lower costs in the early stages of home ownership when interest costs are high. In fact, one U.S. home ownership strategy is to pay off a house very slowly, since the interest costs are subsidized by government.

In Canada, the federal government chose a different policy tool to accomplish a similar result.

Instead of giving you a deduction foryour payments, the Canadiantax department saves upthe entire tax break for when you sell your family home. If duringthe years you own the property, the value increases, that gain is tax-free.

• Feds tighten mortgage requirements,targets foreign money
• Vancouver real estate sales cool, but prices remain stable

Earlier this month, Finance Minister Bill Morneauannounced changes in the lawto try todeny foreign buyers the taxbreak. Under the old rule,when you sold your principal residence you didn't even have to mention it to the tax department.

Just asU.S.interest tax deductions affecthow people buy and pay off their houses, the Canadian policyhas its own consequences.

Supersize me

When property prices are on the way up, rising more than 20 per cent in a year as they have in Toronto and Vancouver, for tax purposes, there is almost no better place to keep your money.

• Why smart money is still investing in Canadian houses
• House prices may stay high in Canada: Here's why

In fact, a good tax strategy might be to buy a house with the biggest mortgage you can afford the payments on. The law can also make ita good strategy to up-size when you can afford it.

The math is clear. If you put down $100,000 on a million-dollar home, and get a $900,000 mortgage for the rest, you own 10 per cent of the house while the bank owns 90 per cent. But if that $1 million home goes up in value by 20 per cent, the bank doesn't get a share of that increase all of the capital gains are yours.

Sell, and you've just turned a $100,000 investment into $300,000, tax-free.

That's also why there are so many contractors who buy a house and keep it for a year while they fix it up for resale.

Not only do they get the standard capital gains that other sellers get, if they do a good job on the renovation, they get an added premium. By claiming the house as a principal residence, all the money they earn is free of tax althoughsometimes, the CRA doesnot accept such claims.

Retirement strategy

The capital gains tax also affects elderly homeowners. While house prices are rising, retired people, especially the well-heeled, have little reason to sell their houses and downsize. Capital gains on their houses are tax-free, but the income fromthe proceeds of selling a house that are invested outside tax shelters (such as retirement savings plans, tax-free savings accounts andregistered retirement income funds)isfully taxable.

Canadian house prices have continued to increase over the very long term. With population continuing to risestrongly, that's unlikely to change over thelong term.

That means people who buy a house with the intent of raising a family will very likely be able to take advantage of the federal capital gains break on principal residences even if real estate goes off the boil for a few years.

As I've mentioned in the past, when my family came back to Canada at the end of the 1990s, we visited friends who told us their home had just climbed back to the value they had purchasedit for 13 years before.

Investment strategy

If you own a home, declining house prices are bad for your finances in any case. But the capital gains tax break makes it even worse.

For some potential homebuyers, the effect ofa medium-termslide in property prices and its impact on the capital gains advantagecould alter the calculus for thinking of a home as an investment.

• Why smart money is still investing in Canadian houses
• House prices may stay high in Canada: Here's why

And unlike other investments that can be claimed as a loss when they fall in value, a house cannot. In other words,capital gainson your principal residence are sheltered from tax. But so is a capital loss.

It'shard to be sureto exactly what degreecapital gains tax breaksaffect people's decisionto usetheir principal residence as aninvestment. But it would seem that during a period of declining prices, that tax break would have the effect of further reducing demand for houses.

Follow Don on Twitter @don_pittis

More analysis by Don Pittis