Flaherty: No bubble busting 'at the moment'

“Not everyone is enamoured of the Canadian real estate market. Financial author and former member of Parliament Garth Turner has been talking himself hoarse warning against speculating in what he believes to be a doomed market.

He said the current run in prices is being fuelled by record low interest rates, and any gains are liable to be erased as the Bank of Canada moves rates higher and makes many current mortgages unaffordable for homeowners.

The recession that gripped the world over the last two years was rooted in inflated U.S. real estate prices, as those with bad credit obtained easy mortgages and drove prices to unsustainable levels. Some markets -such as Phoenix – have seen prices fall more than 50 per cent as foreclosures rise and homeowners give up on their houses.

“Currently real estate is a fad, a fetish, a desire,” he said. “It is being bid higher in a bubble by a large whack of new buyers who could not afford a home if rates were returned to historic levels.

“So, an investor in residential real estate today is gambling.”

– Globe & Mail article

In the future (which starts in a few months), inflation, rates and taxes will all rise. The interest rate thing we’ve done to death. The bond market will begin to jump fixed-term mortgage rates in the Spring, and the Bank of Canada will take care of VRMs a couple of months after that.

Inflation will be robust, but modest. No hyper-inflation to make the gold bugs happy (say, where are they this week?). Not enough to impact real estate or make debts easier to pay. Just something less than 5% – enough to erode everyone’s paycheque.

So, what about taxes?

Reader Stan asks: “Please let me know the likelihood of the Government taxing gains on principle residence. It seems this is a very probable place they will look to increase government revenues. What would you guess the tax amount could be?”

Good one, Stan. I actually think this is possible – but only after the next federal election.

To review, Canadians are allowed to declare one house at a time as a principal residence, and you actually have to live there. The gains you make over the cost of acquisition are yours to keep tax-free. This contrasts with money made on, say, a rental property, 50% of which are taxed at your marginal rate – the maximum possible tax being around 25%.

So, home ownership comes with a massive tax subsidy, as well as the big interest rate subsidy currently existing. Of course, this tax-free thing helps to encourage the casino attitude which has emerged lately, as people buying homes with virtually nothing down, planning to sell in a year or two with big gains to throw into another house. This does nothing but encourage speculation and raise shelter costs for everyone.

At least, that’s what they’re thinkin’ these days at the Department of Finance.

In contrast, Americans have long paid a capital tax on house prices with the ability to deduct mortgage interest (and local taxes) from taxable incomes. That’s changed recently so homeowners there can keep the money they make on long-term houses, or easily roll profits into new ones. Plus, they keep their rate deductibility.

So, could we have a house tax in Canada?

You betcha.

The federal government could just eliminate the tax-free status of principal residences, but that’s likely too big a first step. They might continue to exempt a certain amount of the gain from tax if a new home is purchased, but that poses problems as to the amount, since $700,000 doesn’t go as far in North Vancouver as it does in Truro. They might bring in a reduced rate of capital gains tax on residential real estate, say 5% above the adjusted cost base, but that would be vociferously opposed by the powerful realtor and developer lobby as posing a barrier to home ownership. There could be a real estate exit tax, which lets people own a principal residence tax-free for the child-rearing years, then levies a 7% or 10% fee on the proceeds when anyone over the RRSP age (71) sells out. But a tax on Boomers? Pshaw.

No, what is more likely is something like the 15% tax in Germany on profits from real estate someone has owned for less than ten years. Or the Land Speculation Tax that existed in Ontario decades ago that taxed ‘unearned increases’ in the value of development property. Or there could be a real estate version of the financial transactions tax which is gaining popularity among economists – taxing excessive activity. Bidding wars come to mind.

This, in fact, is the most likely – an action done to curb speculation, while raising revenues. Anyone selling a home within two or three years for more than they paid would have the ‘windfall’ subject to capital gains. As I said, that would exempt a minimum 75% of the profit, and leave the rest taxed at the marginal rate of the owner(s). Without a doubt, that would also dampen the market – and might just prove popular among Canadians fed up with flippers, condo liner-uppers, the 5/35 no-equity, no-savings crowd and an industry utterly incapable of moderation.

The point is simple, Stan. The government is so far down the debt hole they’re looking up kangaroos’ behinds. That means taxes must increase since the economy cannot grow enough to solve this. But taxing incomes means consumers will spend less; not good when the economy is 60% dependent on that. Ditto for jacking the GST up again – another blow to consumerism.

Meanwhile billions in equity have been made without effort thanks entirely to the government policy of dirt cheap money.

Not hard to see where this one might be going.